Capital gains, interest income and dividends are all taxed differently in Canada, giving them different tax advantages, depending on your income level and the accounts where investments are held
With tax season upon us, here's a simple reminder of how each is taxed.
Profits made on the sale of securities such as stocks, bonds, mutual funds and exchange-traded funds get preferential tax treatment from the Canada Revenue Agency because only 50 per cent of the gain is subject to tax.
Half of the capital gain is reported on your tax return as regular income and will be taxed at your marginal tax rate.
Gains are calculated by taking the sale price and subtracting the adjusted cost base, or the amount you paid for the security, as well as any fees or commissions incurred to buy it.
To boost your tax savings, use capital losses to offset taxable capital gains.
If you've sold securities at a loss, use those amounts to offset capital gains in the current tax year or dating as far back as the three previous years. Losses can also be carried forward indefinitely to offset future gains.
Day traders, beware. If the CRA determines most of your income comes from capital gains, the agency might treat it as business income and 100 per cent of the gains will be subject to your marginal tax rate.
The CRA considers factors such as trading frequency, how long the securities are held and how much of the day is spent trading to determine whether or not an investor is day trading as their primary job. For those who are very active traders, it's a good idea to keep records of trading activity and consult with professionals about whether the activity could be viewed as a business.
Interest income from securities such as bonds or Guaranteed Investment Certificates is fully taxable in the hands of the investor.
All of the interest earned is reported on the investor's return and taxed at their marginal tax rate, making it one of the least tax-efficient investments, unless they're held in a registered account such as a Tax-Free Savings Account.
Along with capital gains, dividends also get preferential tax treatment.
Taxes on dividends are calculated differently depending on whether they're eligible (typically issued by publicly traded companies) or non-eligible (usually issued by private small businesses).
Eligible dividends are usually preferred by investors because they come with a bigger dividend tax credit.
The credit is meant to avoid double taxation of dividends since companies use after-tax dollars to pay eligible dividends.
Foreign dividends are generally fully taxed on your return, but investors may be able to claim a tax credit if the foreign country withheld tax on the payout.
Tax savings not the top priority when investing
Tax savings are a key consideration when deciding which investments are best held in various accounts, but it's by far not the most important factor, according to one financial planner.
Risk tolerance, time horizon, investment goals, market conditions, diversification and an investor's overall financial situation are other, more pressing priorities in investment decisions, says Alysha To, a senior financial planner with a specialization in tax and estate planning at Richardson Wealth.
"For instance, a young investor looking for growth may have most of their funds in TFSAs, and it may not fit a growth mandate to hold a majority in investments that produce interest income. When comparing the potential returns of different investments, a more speculative stock with the potential for high capital gains may produce more taxable income than interest income," she said.
When looking at tax savings, an individual's tax bracket can come into play.
She says those in a higher tax bracket might find greater tax savings with capital gains than dividends and vice versa for investors in lower tax brackets.
"Consideration should also be given to restricted access to capital, particularly with regard to time horizon and use of funds. Investors should consider how easily they can convert their investments into cash when needed. Some securities are more liquid than others, and holding too many illiquid assets could limit an investor's ability to access their funds when necessary," she said.
Michelle Zadikian is a senior reporter at Yahoo Finance Canada. Follow her on Twitter @m_zadikian.