If you are the average Canadian, you lose 23% of your earned income to tax 1.
That’s equivalent to 3 months of full-time work. The fraction is even higher if you are a high earner.
I get it. Taxes are boring. Very boring. But it pays to learn about them.
For example, did you know that you pay less tax on investment income than you do on your earned income?
Canadian dividends and capital gains are taxed at lower rates than your earned income.
Even better, is that you pay zero tax from investment income in the tax-sheltered Tax-Free Savings Account.
This provides an incentive to invest, especially as your income increases.
The aim of this post is to help you better understand taxes, and how they apply to investment income.
I’ll do my best to make this as short and exciting as possible. But there is only so much I can do to make taxes fun. Like all worthwhile things in life, self-discipline will be required.
Table of Contents
The Progressive Tax System: The Foundation
The progressive tax system is critical to the financial lives of all Canadians.
This system sets the foundation for how income is taxed on employment income, interest income, dividend income, and capital gains income.
Understanding this system also solves the misconception that earning more will result in less take-home pay.
This is false. It does not occur. Instead, additional income is taxed at a higher tax rate.
The system is based on tax “brackets”, where each bracket covers a range of income.
Each of these brackets has a unique tax rate. And these tax rates get “progressively” higher with each tax bracket.
So, higher income is taxed at higher rates.
Federal & Provincial Tax Brackets, 2022
Here you can see your federal tax brackets in the right-hand column of the table. The credit for this table belongs to turbotax.ca.
That’s great and all, but what about provincial taxes?
Provincial taxes are charged in addition to your federal taxes.
Since the federal and provincial brackets are different, you can “overlay” federal and provincial tax brackets.
This overlay results in your combined federal/provincial tax brackets. here is an example of the combined brackets (and rates) for Ontario from taxtips.ca.
These are the tax brackets that you care about. Your highest combined bracket matters when you earn extra income. Let’s dig into that idea.
Your Marginal Tax Rate
The tax rate for your highest bracket is called your marginal tax rate.
Every extra dollar you earn will be taxed at your marginal rate.
As your earnings increase, you will eventually move into the next tax bracket. When this happens, your marginal tax rate will increase.
This stuff is all abstract, so let’s go through an example.
Example: Marginal Tax Rate
Jake (that’s me) lives in Ontario, Canada, and has an employment income of $84,000/year.
As per the above combined tax brackets, Jake’s combined marginal tax rate is 31.48%.
For every extra $1,000 extra earned, Jake pays $315 to the taxman. He pockets the remaining $685.
If Jake’s income were to increase to $100,000/year, he would enter a new tax bracket and his combined federal and provincial marginal tax rate would be 43.41%.
For every extra $1,000 earned, Jake now pays $434.10 to the taxman and pockets the remaining $565.90.
Although Jake’s tax rate goes up, he never takes home less money by earning more. This is a huge misconception that misleads people into avoiding raises.
Marginal Tax Rate vs. Average Tax Rate
Your average tax rate, also called your effective tax rate, is the fraction of your total income that is paid as tax.
Average Tax Rate = Total Tax Paid / Total Income.
Your average tax rate will be lower than your marginal tax rate since the marginal tax rate only applies to the portion of income in your highest tax bracket.
And your average tax rate increases as you earn an extra income because the extra money earned will be taxed at a higher rate.
Example: Average Tax Rate
Sarah makes $100,000 per year. For simplicity let’s assume she lives in a fictitious country with the following tax brackets:
|Income Bracket||Tax Rate||Tax Owed per Bracket|
|First $20k||0%||($20k)(0%) = 0|
|$20k to $60k||20%||($60k – $20k)(20%) = $8k|
|$60k to $90k||30%||($90k – $60k)(30%) = $9k|
|$90k to $110k||40%||(100k – $90k)(40%) = $4k|
Note that Sarah’s marginal tax rate is 40% since she makes $100k/yr.
Sarah’s total tax paid is the sum of the tax owed for each bracket. I show this math in the right column. Therefore, her total tax is equal to $8k+ $9k + $4k = $21k.
Sarah pays a total tax bill of $21,000 on $100,000 of income. So, Sarah’s average (or effective) tax rate is 21% – $21k/$100k.
But what happens to the average tax rate as Sarah earns more?
As Sarah earns more, a greater proportion of her income will be taxed at her 40% marginal rate. Sarah’s average tax rate will therefore increase as she earns more.
Your Tax Brackets and Inflation
After 30 years, the average income will double with inflation. If tax brackets stay the same, everyone will pay more tax.
Sounds like a great deal for the government.
But there is a way to combat this effect. The upper and lower dollar values of each bracket will migrate upwards each year to adjust for inflation.
This keeps the tax rates the same in “inflation-adjusted terms” unless there are changes to government tax policy.
Use A Tax Calculator To Find Your Marginal And Average Tax Rates
It is important to understand the different tax brackets and how they work, but manually calculating your total provincial and federal tax is not a good use of time.
Instead, there are many calculators that will provide you with your income tax breakdown for your region.
Here are some of the calcualtors I like to use:
With these calculators, you can figure out your:
- Marginal tax rate (combined)
- Average tax rate (combined).
- CPP/EI premium deductions.
- Your after-tax income.
How does the Progressive Tax System Relate to Investment Income?
The tax system we just covered sets the foundation for the taxation of your interest, capital gains, and dividend income. These tax rates are tied to your marginal rates.
In addition, investment income counts towards your total (gross) income. Therefore, money made from your investments can send you into higher tax brackets.
Top 8 Books To Build Wealth
Tax Sheltered Accounts
Tax-sheltered accounts protect you from paying taxes on investment income.
Understanding taxes on investment income can help you see how sheltered accounts help you. With this knowledge, you will be armed to efficiently allocate investments to increase after-tax wealth.
I will not dig into the mechanics of each tax-sheltered account. But I will provide links to resources so you can learn about each account type.
What is a Capital Gain?
A capital gain is an increase in the value of an asset.
You have a capital gain if you sell an asset for more than it was purchased. Such assets include stocks, real estate, and even collectibles.
Capital Gains Income = Asset Selling Price – Asset Purchase Price
Example: Capital Gains Income
Jake bought 1 share of Amazon stock for $1,000/share. He sold the share for $3,000 three years later. Jake made a $2,000 capital gain. *Assumes zero commission transaction.
How are Capital Gains Taxed in Canada?
In Canada, 50% of your realized capital gains income is taxed at your combined marginal rate.
So, in all provinces, you pay half the tax on capital gains income as you do on regular income
Canada Federal Tax Brackets 2022
The First $50,200
$50,200 up to $100,400
$100,400 up to $155,600
$1555,600 up to $221,700
Long Term vs. Short Term Capital Gains
Unlike the U.S, Canada does not break out capital gains income into “short-term” capital gains and “long-term” capital gains.
I originally thought we fell under the same rules here in Canada. I was wrong.
All capital gains have the same tax rate in Canada.
In the U.S., short-term capital gains apply to assets that are held for less than one year.
These short-term capital gains are taxed as regular income. There are no tax benefits for short-term capital gains in the U.S.
If the security is held for more than one year, U.S. citizens have a long-term capital gain that gets preferable tax treatment.
What Is A Capital Loss?
A capital loss occurs when you sell the asset for less than the purchase price. Capital losses on investments can be used to reduce the tax payable on capital gains through tax loss harvesting. I talk about this below.
Example: Capital Loss
Jake buys one share of Boeing for $400 and sells the share at $200. Jake suffers a capital loss of $200.
Realized vs Unrealized Capital Gains/Loss
Capital gains or losses are only “realized” once you sell your asset or security. Otherwise, the increase in value exists only on paper.
I like to look at a loss or gain as only being “real” once the capital loss or capital gain is realized.
Unrealized capital gains and losses do not trigger taxes.
You don’t make money until you realize the capital gain. And most importantly, you don’t lose money until you realize the loss.
However, many spend as if they are richer when unrealized gains are present. This is called the “wealth effect” and it’s something to watch out for.
The wealth effect is common when our homes increase in value or the stock market is doing well.
Example: Realized Capital Gain
Jake bought $10,000 of the VOO S&P 500 ETF in February 2020. VOO dropped by 30% during the COVID crash in March 2020.
Jake had an unrealized loss of 30% in March 2020. The loss was never realized because he never sold his VOO shares.
Instead, Jake’s VOO shares are above the Feb 2020 highs. Jake would have only had a true loss if he sold VOO in March 2020.
By holding, Jake received dividends from VOO. These dividends are taxed. I disuss more on dividend tax below.
To learn more on S&P500 dividends, you can read this post on the Power of S&P500 dividends.
What is Tax Loss Harvesting?
Tax-loss harvesting helps cushion the blow of losses. It allows you to use realized capital losses in a year to offset realized capital gains. Taxes are then owed on the net capital gains for that year.
This isn’t very applicable to long-term index investors, because you won’t be realizing any capital gains while you are holding index funds and getting rich slowly.
Read more about tax-loss-harvesting here.
Can I Use Tax Loss Harvesting in the TFSA or RRSP
No. You cannot.
Tax-loss harvesting does not apply to losses incurred in a tax-sheltered account. The inability to harvest losses in the TFSA or RRSP motivates me to preserve my wealth in these accounts.
Therefore, I treat the contribution room like gold and do not do any speculative buying. If you want to gamble, do it in a taxable account.
But preferably, you don’t gamble at all.
Example: Tax Loss Harvesting
Jake sells stock A for a $50,000 capital gain. His capital gains income tax rate is 15%.
The tax owed on his capital gains income is: (0.15)($50,000) = $7,500.
But Jake also has a stock B that is down $10,000. The $10,000 loss on Stock B can be used to offset the $50,000 gain on Stock A.
The result is $40,000 of net taxable capital gains income. Jake’s total capital gains tax owed is, therefore (0.15)($40,000)= $6,000.
Jake saves $1,500 in tax by harvesting the loss of stock B.
Capital Gains Tax: Sale of Principal Residence
Capital gains income made from the sale of your home (principal residence) is not taxed in Canada.
In Canada, your home must be the principal residence for every year you owned it to be a tax-free capital gain.
Otherwise, a portion of the capital gains income will be taxed. Read more about tax on your principal residence in Canada here.
Tax-free capital gains on your home are an incentive that works in favor of homeownership. For more on the decision to buy a home, you can read the post I wrote to help you make a rational Rent vs. Buy decision.
The Capital Gains Adjusted Cost Base (ACB)
The adjusted cost base (ACB) allows you to reduce your taxable capital gains income by the amount you spend to buy, sell or improve the asset.
Effectively, the ACB adjusts the purchase price upwards, thereby reducing capital gains income.
This article provides more detail on the ACB.
The ACB is the initial purchase price, plus costs to acquire the asset such as commissions, plus capital improvements. Therefore, costs associated with improving the asset, such as a home renovation, count towards the ACB.
Example 1: Jake purchases 100 shares of company XYZ for $10/share, for a total of $1,000. He paid a $10 commission fee. The ACB is $1,000 + $10 = $1,010.
Example 2: Jake buys a rental property for $200,000. Jake puts $50,000 into renovations and pays the real-estate agent 5% ($10,000). His total ACB will be: $200,000 + $50,000 + $10,000 = $260,000.
If Jake sells the rental property for $400,000, he will pay taxes on the difference between the asset selling price, minus the ACB. Jake will have a capital gains income of $140,000. *This example doesn’t account for selling costs.
Taxes on Dividend Income
Dividends are exciting. They can be used as a passive income source to fund a lifestyle, or they can be reinvested to fuel further compounded growth.
Regardless of how you use your dividends, it’s useful to understand how they are taxed.
Dividends from Canadian businesses are taxed differently than dividends from foreign businesses.
Canadian dividends get good tax treatment and are at lower rates relative to your normal income as per the chart below.
Foreign dividends are different. They do not get preferential tax treatment. These foreign dividends are instead taxed as regular income.
The only way to avoid all taxes on dividends is to hold the dividend-producing stock in a tax-sheltered account like the TFSA, RRSP, or RESP.
By understanding dividend taxes, you will be able to limit losses to tax. You can do this by allocating dividend-yielding stocks and ETFs among tax-sheltered and taxable accounts in a smart way.
Dividend Mechanics – How does a Dividend Work?
By owning stock, you own a fraction of a business.
The business has two main ways of returning money to shareholders. (1) It can buy back shares, or (2) it can pay a cash dividend.
Alternatively, the business could reinvest its earnings back into the business to increase future earnings. A business will elect to pay a dividend when there is no better alternative use of cash.
Dividend payments are normally made once per quarter. That equates to one payment every three months.
Why do Canadian Dividends Have Low Tax Rates?
Dividends from Canada are taxed at lower rates than normal income.
When a company pays a dividend, it does so with after-tax earnings. Therefore, the company pays tax on its earnings before distributing a portion of earnings to you, in the form of a dividend.
you are being double taxed if you are taxed again when you receive the dividend.
The lower dividend tax rate is meant to even out the playing field by preventing earnings from being taxed twice. I’ll show exactly how this works below.
The lower tax rates on dividends do not apply to foreign dividends. This is because earning from these companies are taxed by the foreign government, so it’s not double taxation.
How do taxes effect dividend reinvestment?
Dividends are taxed before they are reinvested. There is no way around this. Taxes, therefore, eat into your compounded returns for unsheltered dividend-yielding securities or ETFs.
What about dividends that are automatically reinvested under the Dividend Reinvestment Program (DRIP)?
It turns out that the automated DRIP program will not save you. Dividends under the DRIP are taxed before they are reinvested.
Eligible and Ineligible Dividends
Canadian dividends are classified as either eligible or ineligible.
Companies that pay eligible dividends pay a higher tax rate on their earnings relative to companies that pay ineligible dividends.
Nearly all Canadian companies listed on the TSX pay eligible dividends. You likely don’t have to worry about ineligible dividends.
How Canadian Dividends Count Towards Your Gross Income
When you earn $1,000 of eligible Canadian dividends, it counts as $1,380 of total income.
The company already paid tax on its earnings before sharing earnings with you as a dividend. Therefore, your dividend is “grossed-up” by 38% to reflect the pre-tax equivalent.
The gross-up rate is 38% for eligible dividends and 15% for ineligible dividends. It is the grossed-up dividend that counts towards your income, not the dividend payment you receive.
Keep this in mind as the grossed-up amount of the dividend income can unexpectedly take you into a new tax bracket.
This only applies in a taxable investing account. Dividends received in a TFSA or RRSP do not affect your taxable income.
How Are Foreign Dividends Taxed
Dividends from business in foreign lands, such as the U.S. have no tax advantages in Canada. Foreign dividends are taxed as regular income, at your marginal rate.
This is an incentive to keep foreign dividends in tax-sheltered accounts. You just have to watch out for withholding tax. More on that below.
How To Find Your Tax Rate On Dividend Income
Check out the income tax tables at Taxtips.ca to find your tax rate for eligible and ineligible dividends.
You will need to find your specific province, and that will bring you to charts that show your combined federal/provincial tax rate for:
- Normal Income;
- Capital Gains Income; and
- Canadian Eligible Dividend Income.
I only cover this complex option to who you exactly why Canadian dividends have lower tax rates in Canada. It helps you develop a robust understanding of dividend taxes.
This complex version also provides the basis for the 38% dividend gross-up that increases your total taxable income.
Tax owed on Canadian dividends can be calculated with a 4-step process. Firstly, the Canadian dividends are “grossed up” to reflect the dividend value before the company paid tax on its earnings.
Secondly, you find the tax owed on this grossed-up amount at your marginal tax rate. Next you find the dividend tax credit amount. Finally, we reduce the tax owed by the amount of the tax credit.
The three variables needed to determine your dividend tax rate are:
- Your marginal tax rate;
- The dividend gross-up rate; and
- The dividend tax credit (provincial and federal).
Step 1: Gross-Up The Dividend
Firstly, we must “gross-up” our dividend amount to reflect the company’s pre-tax earnings. The gross-up is used to reflect the dividend amount before the company paid taxes on it’s earnings. In step 3 we will use the gross up amount to prevent double taxation by using the dividend tax credit.
Eligible dividends are grossed up by 38% while ineligible dividends are grossed up by 15%. Note that the grossed-up amount is what counts towards your total income. This can unexpectedly bring you into a higher tax bracket.
Step 2: Find Tax Owed at Marginal Rate
Now we multiply the grossed up dividend by our marginal tax rate to find the total ax owed.
Step 3: Find the Canadian Dividend Tax Credit Amount
The dividend tax credit evens out the playing field by reimbursing you for the tax already paid by the company on its earnings.
The federal dividend tax credit in 2021 is 15.02% of the eligible dividend amount and 9.03% of the ineligible dividend amount.
Multiply the grossed-up dividend amount by the tax credit to find the tax credit dollar value.
Step 4: Deduct The Tax Credit Amount
The dividend tax credit amount from Step 3 is subtracted from the tax owed calculated in Step 2.
Each province also has its own dividend tax credit amount for eligible and ineligible dividends.
This article provides more detail on the Federal Dividend Tax Credit.
Note that are also provincial dividend tax credits that apply in addition to the federal dividend tax credits.
Example: Canadian Dividend Tax
Jess earned $1,000 in eligible Canadian dividend income from a Canadian company. Jess wants to find out how much tax is owed.
She earns $100,000 per year, and therefore has a 26% marginal federal tax rate.
Step 1: Jess first finds her grossed-up dividend amount by multiplying her eligible dividend received by 1.38. The grossed-up value of the $1,000 dividend is $1,380.
Step 2: Jess finds the marginal tax owed on the grossed-up amount: ($1,380) (0.26) = $358.80.
Step 3: Jess needs to find the total value of the tax credit. The federal eligible dividend tax credit is 15.02% of the grossed-up dividend calculated in step 1. Therefore, Jess’ tax credit amounts to: (0.1502)($1,380) = $207.28.
Step 4: The tax credit will reduce the tax owed on the grossed-up amount, as calculated in step 2 ($358.80). So, Jess owes $358.80 – $207.28 = $151.52 in federal dividend tax on her $1,000 of eligible dividends earned.
The overall dividend tax rate that Jess pays on $1,000 of eligible dividends is 15.5%. This tax rate is far less than her marginal tax rate of 26% for regular income.
This method of grossing up dividends and applying the tax credit is how tax rates for eligible dividends are derived. I suggest you simply use the tables once you understand the mechanics of dividend taxes.
Interest income is taxed as ordinary income in Canada.
You may wonder, what assets generate interest income?
Assets that generate interest income include Guaranteed Investment Certificates (GICs), High-Interest Savings Accounts (HISAs), Bonds, and Money Market Funds.
These interest producing assets are more stable relative to stocks. Therefore, they’re often used for shorter time-horizon goals. You can learn more short-term savings assets in my post on Short Term Savings.
It often makes sense to place interest-paying assets in a tax-sheltered account, becuase these assets are tax inefficient. I keep my bonds in the RRSP for this reason.
Foreign Withholding Taxes
With Canada representing only 3% of the global stock market, many Canadians decide to invest outside of Canada.
I know I do, becuase I know that global diversification will maximize my risk-adjusted returns.
I discuss more about the essential topic of risk and returns in this post on intro to investment risk.
No matter how you spin it, you can’t get away from withholding taxes unless you hold US listed assets in the RRSP in US dollars. It doesn’t matter if you hold foreign stocks directly, via an ETF or via a mutual fund.
What is Foreign Withholding Tax?
Withholding tax is “withheld” by the home country’s government when income generated within that country is paid to foreign investors.
That impacts you when you own foreign securities that produce dividend or interest income. Such securities include individual stocks, ETFs, Bonds or REITs.
Note that I didn’t say anything about capital gains income.
That’s becuase these withholding taxes do not apply to foreign capital gains income.
Capital gains from foreign stocks are taxed just like capital gains form Canaidan stocks, at 50% of your marginal rate.
The actual withholding tax rate for each country will depend on the country. I don’t have time to research every country, so I’ll just cover the US as this is the most commmon case.
U.S. Withholding Tax
The U.S. government applies a withholding tax of 30% on interest and dividends paid to foreign investors.
But we are lucky here in Canada. We benefit from a tax treaty that reduces these withholding taxes.
The treaty reduces U.S. withholding tax to 15% for dividends and 10% for interest income generated by U.S. securities and paid to Canadian investors.
US Withholding Tax In The TFSA
The TFSA does not shelter you from foreign withholding tax.
Say you receive $1,000 of dividends from U.S. stocks held in your TFSA. 15% of that $1,000 ($150) will be stripped away. You will only after-tax dividend of $850 in your TFSA.
This is because the U.S. government charges the withholding tax, not the Canadian government. The US government does not acknowledge the TFSA for withholding tax purposes.
But they do, however, acknowledge the RRSP.
If you want to learn more, I made wrote a post about investing in US Stocks in the TFSA.
US Withholding Tax In The RRSP
You are sheltered from US withholding tax in an RRSP. This is because the U.S. government recognizes the RRSP.
However, you can only avoid withholding tax if you hold the US-listed security directly, meaning you must exchange currency from CAD to USD.
Note that this exchange adds complexity to your investing life. It’s worth reflecting to see if the additional complexity is worth the savings on withholding tax.
US Withholding Tax In A Taxable Account
What happens when you receive dividends or interest income from a US stock or bond in a taxable account?
The Canadian government will tax this income as regular income at your marginal rate.
So does withholding tax apply as well?
The withholding tax is withheld by the US government, but you get reimbursed with the Foreign Tax Credit. In an unsheltered account, you essentially avoid withholding tax.
Foreign dividend or interest income is taxed as regular income in your taxable account. I don’t know if the tax credit applies to other countries as well.
Congratulations. Taxes are boring. The fact that you made it this far is impressive.
A solid understanding of taxes is useful:
- I can help you avoid making the mistake of avoiding a raise because you thought you’d take an after-tax pay cut. Maybe you can educate others on this common misconception as well.
- It helps you see the value of the TFSA and RRSP for investing. This all becomes clear once you understand how taxes apply to investment income.
- Taxes rates are lower on capital gains and dividends, which can incentivize investing.
- Your knowledge of taxes can help you locate your investments across accounts to maximize your after-tax wealth.
Other key points from this post:
- Capital gains income is taxed at 50% of your marginal rate in Canada. They are tax efficient.
- Canadian dividend income is taxed at a lower rate than regular income because the business already paid tax on their earnings. Dividends are tax efficient.
- Interest income is taxed as regular income at your marginal rate. GICs, Bonds, and HISAs are therefore tax-inefficient.
- Foreign dividends and foreign interest income are taxed at your marginal rate. They are tax inefficient.
- You can’t avoid foreign withholding tax in your TFSA. But you can avoid it if you directly hold U.S. securities in your RRSP. Withholding tax can be recovered via a tax credit in an unsheltered account.
Getting caught up in achieving tax efficiency can make investing complicated. It can result in different investments scattered across the TFSA, RRSP, and taxable accounts.
Do you want to deal with that complexity? That’s a question that only you can answer.
A simple investment portfolio has value, as I discuss in this post. It saves time and energy while preventing emotional attachment to investments.
Hope you enjoyed the guide. Drop a comment or send me an email if you have any questions and join the newsletter to get updates on weekly posts!