I have been asked this question very often, and even more often people did not know that there would be different types of taxes.
First of all YES you pay taxes on investments! But they are not always treated the same way. There are 3 different types of gains one can have on investments and taxation depends on the type of gain. The first and most common form is interest, then dividends lastly capital gains.
Interest is what you normally get at the bank savings account or a GIC. It is essentially what the bank pays you for borrowing from you the same way they charge you interest when you get a loan, however the rate you get is always substantially lower than what banks charge for their money. This is the least tax efficient method of investing, because it is taxed at your marginal tax rate (MTR= the tax rate you pay on your income).
You invested $10,000 and got 5% interest in return, your profit would be $500. We will also assume you are making $100,000 annually and have a MTR at 50%. The tax on your investment return would be 50%, so 50% of 500 is $250 your real return is $250 and real rate of return would be 2.5% without considering inflation.
Dividends are treated differently by the government IF IT IS A CANADIAN CONTROLLED CORPARTION. Dividends are grossed up by 45% and given a tax credit of about 19% at the federal level similar gross up and tax credits are also applied by the provinces by the rates differ. This results in a preferred taxation than interest, bottom line you would pay less tax. This is basically a return of profits from a public company to its shareholders where the company has already paid the tax on it.
We will use the same case as above. $10,000 with $500 in profits at 50% MTR.
So $500 is grossed up by 45% (500 X 1.45 = 725) so now you pay tax on $725 at 50% tax amount is $362.5, but now you get a tax credit of 19% based on $725 tax credit = $137.75 this is the amount the government credits you. So your total tax payable is $362.5 – $137.75 = $224.75, your return is $275.25 your rate of return is 2.75% if the MTR is lower the profits would be higher. As you can see this method is somewhat more tax efficient.
This is the most tax efficient investment method. Capital gain has a 50% inclusion rate, which means that ONLY 50% of your profits is taxed! In essence capital gain is the appreciation of a capital, this could be a stock, real estate or any other capital that has increased in value.
Again the same scenario as above. Now only $250 of your $500 gain is taxed at your MTR (50%), your total tax due is $125, your after tax profit is $375, 3.75% after tax return.
These are the three forms of profits an investment has and each is treated differently for tax purposes. Also please note that these ONLY apply in NON-REGISTERED investments, Registered investments (RRSP, RESP etc.) are not taxed until withdrawal and at withdrawal they are taxed as regular income therefore it is best to keep interest earning investments, and depending on your MTR, your dividend earning investments inside a registered plan.
These are just the basics of taxation on investments, if you need more information feel free to contact me directly.
People don’t plan to fail……..they fail to plan!