Purpose of This Guide on Taxes
The average Canadian loses 23% of earned income to tax 1. That’s equivalent to 3 months of full-time work. If you’re a high earner, the fraction is even higher.
The good news is that tax rates are lower for investment income, such as dividend and capital gains income. So, you have incentive to invest, especially as your income increases.
And it gets better. Tax-sheltered accounts like the TFSA and RRSP can further reduce, or even eliminate, taxes on investment income. The true value of tax sheltered accounts didn’t click until I understood how taxes apply to investment income.
Taxes are boring, but putting in the work to learn will provide a large return on your time spent learning. The aim of this post is to help you better understand taxes, and how they apply to investment income.
The Progressive Tax System
The progressive tax system is composed of multiple income “brackets”. As the income “brackets” increase, the tax rate also increases.
Taxes brackets at “progressively” higher rates as they increase in value.
Your Marginal Tax Rate
The tax rate for your highest bracket is called your marginal tax rate. Every additional dollar you earn will be taxed at your marginal rate. If you keep earning more, you’ll end up in the next bracket and your marginal tax rate will increase further.
In addition to federal tax brackets, you also have provincial tax brackets. Provincial taxes are charged in addition to federal tax. Federal and provincial tax brackets overlap to produce combined federal/provincial tax brackets. These are the tax brackets you care about, and you can find them for your province at taxtips.ca.
Marginal Tax Brackets and Inflation
The upper and lower dollar values of each bracket will migrate upwards each year to adjust for inflation. Tax rates for each bracket generally remain unchanged in “real terms” unless there are changes to government tax policy.
Example: Marginal Tax Rate
Jake lives in Ontario, Canada and has employment income of $84,000/year. As per the above chart, Jake’s federal marginal tax rate is 20.5% since he falls within the $48,454 – $97,069 federal tax bracket.
But wait, there’s more. Jake’s provincial marginal tax rate is 10.98% and applies on top of the federal tax rate. Therefore, Jake has an combined federal and provincial marginal tax rate of 31.48%. For every extra $1,000 earned, jake pays $314.80 to the taxman and pockets the remaining $685.20.
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
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, unless you fall within the lowest tax bracket. And your average tax rate increases as you earn 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 has 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%.
Sarah’s total tax paid is the sum of the tax owed for each bracket. The total is $8k+ $9k + $4k = $21k. Sarah therefore pays $21,000 of tax on $100,000 of income. So, Sarah’s average (or effective) tax rate is 21% – $21k/$100k.
Sarah’s average tax rate will increase with her income because a greater proportion of her income will be taxed at her 40% marginal rate.
There are many calculators that will provide you with your income tax breakdown for your region. With these calculators, you can figure out your marginal tax rate, average tax rate, CPP/EI premium deductions and your after tax income.
I live in Ontario and use this turbotax calculator.
How does the Progressive Tax System Relate to Investment Income?
The progressive tax system sets you up to understand taxes on capital gains, dividend, and interest income.
First, investment income is income. It counts towards your total (gross) income and can send you into higher tax brackets.
Secondly, the tax rates on interest, capital gains and dividend income are directly based upon your marginal tax rate.
Tax Sheltered Accounts
Tax-sheltered accounts protect us from paying taxes on investment income. I will not dig into the mechanics of each tax-sheltered account, however, I provided links to resources so you can learn about each account type.
Understanding sheltered accounts will enable you to efficiently allocate investments to increase after-tax wealth.
How are Capital Gains Taxed?
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.
Long-term capital gains are nice. A captial gain is long term, if you hold the asset for one year or more. In Canada, you pay 50% of the tax for long-term capital gains income, relative to employment income. That’s pretty great.
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 2021
The First $49,020
$49,020 up to $98,040
$97,069 up to $151,978
$151,978 up to $216,511
Long Term vs. Short Term Capital Gains
Let’s clear something up. All capital gains have the same tax rate in Canada. 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, but I was wrong.
In the U.S., short-term capital gains apply to securities that are held for less than one year. 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. These have good tax treatment. The U.S. has specific brackets for long-term capital gains income. Long-term capital gains are taxed at 15% for those who make less than ~$400k/yr.
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 is just an unrealized gain or loss on paper. A loss or gain is only “real” once it the capital loss or capital gain is realized.
Unrealized capital gains and losses have no tax implications.
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. VOO is now above the Feb 2020 highs and Jake now has an unrealized capital gain. Jake would have only had a true loss if he sold VOO in March 2020.
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 likely won’t be realizing any capital gains. 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 serves as motivation to preserve wealth. I treat the contribution room like gold in these accounts.
If you want to gamble, do it in a taxable account.
Example: Tax Loss Harvesting
Jake sells stock A for a $50,000 realized 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.
Jake also has a stock B, with an unrealized loss of $10,000. The $10,000 loss on Stock B can be “Harvested” against the $50,000 realized gain on Stock A.
The realized loss is used to offset the $50,000 realized gain, resulting in $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. This incentive works in favor of homeownership. Check out this post to learn more about the rent vs. buy decision.
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.
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. I view the ACB as a method to “write off” the expenses associated with the capital gain. 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. 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
Dividend income – cash paid to you by a business – can be used to fund your lifestyle, or they can be reinvested to fuel further compounded growth. Regardless of how dividends are used, they are taxed – unless in a sheltered account like the TFSA, RRSP or RESP.
Understanding dividend tax can help you allocate dividend-yielding securities among tax-sheltered and unsheltered accounts to keep more dough in your pocket.
Let’s dig into the reason why a dividend is taxed differently than normal income, and how dividend taxes impact the compound effect of dividend reinvestment.
Dividend Mechanics – How does a Dividend Work?
Roughly 40% of the total stock market (S&P 500) returns through history are attributable to dividends – I made a post on this. It is therefore critical for investors to understand how dividends work. In addition, understanding dividends will give you an intuitive sense of why Canadian dividends have low tax rates.
First, by owning a stock, you own a fraction of a company. When this company earns income it has two ways of returning the money to shareholders. (1) It can buy back shares, or (2) it can pay a cash dividend.
A dividend is a cash payment direct to shareholders. Dividend payments are normally made once per quarter – one payment every three months.
Why do Canadian Dividends Have Low Tax Rates?
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. The dividend you receive has already been taxed by the Canadian government.
We run into a double taxation situation when you are taxed again when you receive the dividend. Your share of the company’s earnings were already taxed before you received the dividend payment. By owning stock, you own a portion of the company.
The lower dividend tax rate is meant to even out the playing field by preventing earnings from being taxed twice. This doesn’t apply to foreign dividends because the foreign government will tax the initial earnings.
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)? You don’t get a break. 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 Total Income
The total amount of dividends earned throughout the year count as normal income, right? Incorrect.
The company already paid tax on its earnings before sharing earnings with you as a dividend. Therefore, your dividend is “grossed-up” 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.
So $10,000 of eligible dividend income will add $13,800 to your total income. The grossed-up amount of the dividend income can unexpectedly take you into a new tax bracket.
How Are Foreign Dividends Taxed
Foreign dividends are neither eligible nor ineligible. 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 Dividend Income Tax Rate
Simply check out the income tax tables at Taxtips.ca to find your tax rate for eligible and ineligible dividends. The charts show you your combined federal/provincial tax rate for normal income, capital gains income, and dividend income.
The complex option helps you develop a robust understanding of dividend taxes. It helps you dig into the mechanics of dividend tax in Canada. It also provides the basis for the 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 she owes.
Jess 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%. Her dividend tax rate is far less than her marginal tax rate of 26% for regular income.
Tax rates in the tables provided in the simple version are derived this way. I suggest you simply use the tables after fully understanding the mechanics of dividend taxes.
Interest is taxed as ordinary income in Canada. This includes interest from corporate bonds, Guaranteed Investment Certificates (GICs) and interest received from savings accounts. Interest bearing assets are tax inefficient. For this reason, it makes sense to place them in a tax sheltered account.
Interest on government bonds in the U.S. have specific tax rules. For example, income from federal bonds such as Treasury Bills are taxed at the federal level, but not at the state and municipal level. You will need to research the taxes applied to various government bonds as unique cases. Check out this article for more details.
Foreign Withholding Taxes
What is Foregin Withholding Tax?
Withholding tax is “withheld” by governments when income generated within its country is paid to a non-resident.
Withholding taxes will apply to dividend and interest income generated by foreign securities. Such securities include individual stocks, ETFs, Bonds, REITs, ect. The withholding taxes do not apply to foreign capital gains income.
For Canadians Holding U.S. Securities
The U.S. government applies a withholding tax of 30% on interest and dividends paid to foreign investors.
However, we are lucky. There is a tax treaty between the U.S. and Canada that reduces U.S. withholding tax to 15% for dividends and 10% for interest income generated by U.S. securities and paid to Canadian investors.
The income tax charged by the Canadian government applies in addition to the tax withheld by the foreign government. However, we have the Foreign Tax Credit – read more here. In an unsheltered account, the foreign withholding tax amount is returned to you via this tax credit and the dividend or interest income is taxed as regular income.
You are not sheltered from withholding tax in the TFSA. The U.S. government charges the withholding tax and does not care about the TFSA. But you are sheltered from the withholding tax in an RRSP because the U.S. government recognizes the RRSP. However, this only applies if you hold the USD listed security directly, meaning you must exchange currency.
For example, Jake the Canadian receives $1,000 of dividends from U.S. companies held in his TFSA through the ETF VOO. The U.S. government will withhold 15%, or $150. Jake will receive the after-tax dividend of $850 in his TFSA.
Congratulations. Taxes are boring, and you made it this far. I’m proud of you. The value of sheltered accounts and investing become acutely obvious once you understand how taxes apply to investment income. Further, these boring taxes can help you locate your investments across accounts to maximize your after-tax wealth.
We saw that:
- Long-capital gains income is taxed at 50% of your marginal rate.
- Canadian dividend income is taxed at a lower rate than regular income because the business already paid tax on their earnings.
- Interest income is taxed as regular income at your marginal rate.
- Foreign dividends and foreign interest income are taxed at your marginal rate.
- 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.
One point of caution. Getting caught up in achieving tax efficiency can get complex quickly. Especially when you have 3 accounts: the TFSA, RRSP and taxable account. At this point, it can make more sense to forget about tax efficiency for the sake of simplicity. Portfolio simplicity saves time and prevents you from becoming emotionally attached.
Hope you enjoyed the guide. Drop a comment if you have any questions.