Are you curious about how investing taxes are calculated on dividends, interest, and capital gains across the various accounts in your portfolio?
I am by no means a tax expert, but I do have enough knowledge to give general guidelines on how you can figure out your own investing taxes and prioritize your subsequent investments.
Investing Taxes in an RRSP
Let’s start with RRSPs. As you probably know, RRSP contributions and investment growth are taxable only upon withdrawal.
That’s the strategy behind RRSP’s: contribute, let it grow tax-free, and withdraw when you are in a lower tax bracket (hopefully).
The reason that the RRSP works so well as an investment vehicle, is that when you are retired, you will typically be in the lower tax brackets (unless you have a very large portfolio and/or a generous pension). Because of this, you’re able to invest money now before it is taxed while you are at a high tax bracket, and withdraw it when you are in the lowest tax bracket (i.e. retired).
Investing Taxes in a TFSA
The main benefit of the TFSA is that you don’t have to worry about paying investing taxes on anything that you hold within it.
When you contribute to a TFSA, you are doing so with after-tax dollars, meaning that taxes have already been paid by you, on those amounts.
In other words, even if your investments quadrupled in value within your TFSA, you still wouldn’t pay any tax on those gains. You also wouldn’t pay any tax on the dividend or interest income that you may have earned within your TFSA.
Because of this tax efficiency, a common practice when it comes to the TFSA, is to use it for the investments that you think will grow the most, since in the future you’ll be able to take those investments and gains out tax-free.
Investing Taxes in Non-Registered Accounts (Taxable Accounts)
Now on to Non-registered accounts. This is where things can get a bit tricky. There are 3 types of taxes that you need to consider.
- Capital gains tax (preferred)
- Dividend tax from Canadian corporations (preferred)
- Interest tax and dividends from non-Canadian corporations
Investing Tax on Capital Gains
When you profit from selling a stock in a non-registered account, you will be subject to capital gains tax. What are capital gains? A capital gain is the difference between the selling price and buying price of a stock – less the commission.
For example, if you sold a stock for $1,000 (inc selling fee) and paid $800 (inc buying fee), you would have a capital gain of $200.
Capital gains tax is subject to a 50% inclusion rate. This means that 50% of your profit will be included as income.
So in our above example, $100 would be added to your income and taxed at your marginal rate. Or another way to look at it is that any profits from a stock sale in a non-registered account are taxed at HALF your normal marginal rate.
Some Canadian investing tax experts argue that any part of your non-registered investment portfolio that produces interest income such as bonds or GICs should be placed inside a TFSA or RRSP in order to protect that income – due to the fact that it is taxed at 100% of your marginal tax rate.
However: I’d argue that with interest rates on fixed income so low, you’re better off protecting the much larger returns that your equities *should* produce long term. The idea is, should you be more worried about protecting your 1% return on fixed income (even if it gets taxed at 100% of your marginal rate) or the 2-3% dividend returns + 4-6% capital gains that your equities are likely to realize over the long term (even though they do get preferential tax treatment)? To me the math is pretty easy on that one. Once fixed income starts edging into the 3-4% territory, the math starts to get a lot closer in terms of deciding what to keep under the RRSP/TFSA tax-sheltered umbrella, and what to leave outside in the taxable rain.
One additional advantage of keeping your capital-appreciating stocks outside of an RRSP is because you can claim your losses against your gains to reduce your taxes payable. Whereas within an RRSP, losses cannot be claimed.
If in 2020 you sold stock for a $4,000 non-reg portfolio profit and $1,000 in losses, your total profit is now $3,000. To figure out your taxes payable, it would be: $3,000 x 0.50 = $1,500. This $1,500 would be added to your taxable income for that year and taxed at your marginal rate.
This is why you’ll read some tax strategies to sell your losing stocks at the end of the year. The losing amount will be deducted from your total winning amount and reduce your overall taxes.
What if you have a losing stock(s) for the year, but you believe it’s a long term winner? You’re probably thinking to sell it before the end of the year and purchase it again. Not so fast, you have to make sure you don’t violate the superficial loss rule.
What is the Superficial Loss Rule?
According to the Government of Canada’s explanation, This rule applies where a person or affiliated person acquires or had the right to acquire the same or identical property within 30 days after the disposition or 30 days before the disposition of the property in question. The disposition could have been made to anyone. In these cases, the loss on the disposition is denied and the amount of the loss is added to the cost of the substituted property.
In layman’s terms, it simply means that if you sell a stock at a loss, you can’t repurchase the shares back again within 30 days and claim the loss against your gains. However, if you do repurchase the same shares back within 30 days and you profit from it in the future, you can deduct the initial loss against your gain of THAT stock.
- Purchase 10 ABC stock for a total cost of $1000
- Sell 10 ABC stock for: $800
- Loss: $200
- Repurchase 10 ABC stock within 30 days for: $850
- Sell 10 ABC stock in the future for $1200:
- Profit: $1200-$850-200 (initial loss) = $150
- Taxable Amount: $75 ($150 *50%)
As a side note, you should consider the superficial loss rule if you are attempting the Smith Manoeuvre (SM) or want to hold Canadian dividend stocks outside of your TFSA and/or RRSP. The SM suggests to sell your non-reg stock to pay down your house, then REPURCHASE the stocks. If you sell stock at a loss, you should wait 30 days before repurchasing. Otherwise, the loss will be omitted.
Investing Taxes on Dividends and the Dividend Tax Credit
What is a dividend?
Dividends are payments/distributions from public corporations to their shareholders. Dividend paying companies typically pay their distributions on a quarterly basis (every 3 months). You as an investor should see a nice little deposit in your online brokerage account when these dividends get paid out.
Why are dividends tax efficient to shareholders?
Dividends are tax efficient for shareholders because distributions are paid out with after-tax corporate dollars. Meaning that the company pays out the dividend distributions AFTER it has paid all of its taxes to the government.
This is the reason why when you receive a dividend payment from a Canadian public company in a taxable account (i.e. a non-registered account), you are eligible for the enhanced dividend tax credit.
How do I calculate the dividend tax and dividend tax credit?
With the enhanced dividend tax credit, gross-up any dividends that you receive (from a Canadian public corp) for the year by multiplying it by 38% (2020).
- Ex: $1000 dividends received in 2020 * 38% = $1,380
You add this amount to your income for the year. You take this total amount and figure out your marginal tax rate.
- Ex. $55k + $1,380 = $56,380
Multiply your grossed-up amount by your marginal tax rate to figure out total taxes owed.
- $1,380 * 29.65% = $409.17 (for this example we’re using the combined federal and Ontario tax rate/bracket which is 29.65% for 2020)
Calculate Federal Tax Credit and Provincial Tax Credit
- $1,380 * 15.02% (Federal rate) = $207.28
- $1,380 * 10% (ON) = $138
- Total tax payable on $1,000 worth of dividends: $409.17 – $207.28 – $138 = $63.89.
- Or, you can go on the web and calculate it yourself.
How about dividends from foreign companies?
Dividends received from foreign companies do NOT qualify for the dividend tax credit and are 100% taxable. For all intents and purposes, you can treat foreign dividend income the same as interest income or income you earned at a job.
Investing Tax on Interest Income (In a Taxable Account)
What is interest income?
Interest income is interest received from GICs, high-interest savings accounts, bonds, and private loans.
How is interest taxed in a non-registered (taxable) account?
Interest income is 100% taxable. This means that if you earn $1,000 in interest for the year, $1,000 is added to your income and taxed at your marginal rate. (40% tax rate = $400 to be paid in taxes – OUCH!)
In other words, it’s just like you earned the money at a job.
How to Calculate US Capital Gains Tax in a Non-Registered Account
Another common question is how to calculate capital gains tax on US traded stocks within a Canadian non-registered account (in USD).
While the calculations are very similar to trading Canadian stocks, the difference is that the currency exchange needs to be accounted for.
Basically, the buy price and sell price need to be converted to Canadian dollars first prior to calculating capital gains.
Once capital gains after foreign exchange are calculated, the same 50% inclusion rate is used.
To figure out the exchange rate on the day of the trade, the Bank of Canada website has all the forex history you need.
Here’s an example:
- Stock: XYZ on NYSE
- Buy Price USD: $10 x 100 shares = $1,000
- Buy CAD/USD Exchange: 1.41 (on day of buy trade)
- Buy CAD: $1,410
- Sell Price USD: $15 x 100 shares = $1,500
- Sell CAD/USD: 1.43 (on day of sell trade)
- Sell CAD: $2,145
- Capital Gain: $730 minus commissions
- Capital Gains Tax: ($730 minus commissions) x 50% x marginal tax rate
In the above example, if it was simply a stock on the TSX, then the capital gain would be $500 (minus commissions). However, since there may be a loss or gain due to the value and volatility of the USD currency itself, it can work in favour or against the investor.
Another method my accountant told me about is to use an average USD/CAD exchange for all the transactions to avoid looking up the exchange rate on the day of the trade for every transaction. While this may simplify things, you’ll need to work through the numbers yourself to see which option reduces capital gains the most. For a frequent trader, I can see how using a single annual average forex rate can be advantageous.
Personally, to keep things simple, I hold US securities in registered accounts. As per my article on portfolio allocation, US dividends stocks are kept in an RRSP to avoid the withholding tax on the dividends and the occasional USD trade may be made within my TFSA.
Reduce your Investing Taxes by Claiming your Capital Loss
What is a capital loss?
It’s simply where you sell a stock in your non-registered portfolio for a loss.
From here, it just seems like a loss, but there is a bright side. Unlike investments within your RRSP (or TFSA), capital losses within a non-registered portfolio can be claimed against your capital gains for the year (or previous years).
Here are some important facts about capital losses:
- Capital losses can only be claimed on investments within taxable investment accounts (also known as non-registered accounts).
- Only 50% of capital losses can be claimed.
- Capital losses can be claimed against capital gains in the current year, up to 3 previous years or carried forward indefinitely. However, it can be claimed against income on the year of the taxpayer’s death (comforting hey?).
- Tax loss selling must be made before December 24 of that year as it takes 3 days to settle the trade.
How Tax Loss Selling Works – An Example
Say for example Jim (@ 40% marginal tax rate) had $10,000 in capital gains in 2020, but also $4,000 in capital losses. What is the resulting tax payable?
There are two ways to calculate this, both of which turn out with the same result:
- $10,000 – $4,000 = $6,000 x 50% x 40% = $1,200 tax payable
- $10,000 x 50% X 40% = $2,000 capital gains tax; $4,000 X 50% X 40% = $800 capital loss claim; result = $1,200 tax payable.
The last question is why would you sell for a tax loss? The main reason for this, is that sometimes at the end of the year, you realize that you’ve made some bad stock picks that have a low probability of recovering. Why not dump the losers, claim the tax deduction and move on?
What about tax-loss selling or tax-loss harvesting for index investors?
Keep in mind that tax-loss selling primarily applies to investors that pick individual stocks within a taxable account.
It doesn’t apply as much to index investors since as an index investor, you are buying and holding the entire index long-term. You don’t have any “losers” per se, since you aren’t actually trying to pick the winning stocks and avoid the losing stocks (i.e. as an index investor, you are just buying all the winners and the losers).
If an index experienced losses in the year, then you also have to be careful about the superficial loss rule mentioned earlier.
For example, if the S&P/TSX index (the main Canadian index) fell in a given year, you can’t just sell that ETF to claim a capital loss, and then buy it again immediately.
It also looks highly suspicious to the CRA if you sell an index from one provider (ex. Vanguard) and then buy the same index ETF through another provider like iShares. In that case, you are still technically re-buying the same index, and so I seriously doubt that the CRA would rule in your favour as it clearly appears that you are doing this just to minimize taxes.
What you can do (and the CRA has not spoken out against this to the best of my knowledge) is buy a similar ETF to the one that you just sold – then 30 days later, sell that ETF and buy the one that you really want (and had originally). There is no reason to over-complicate your life with stuff like this unless your overall portfolio is large enough that the loss that you experienced represents a decent tax write off. If you are sticking to investing only in your RRSP and/or TFSA, then obviously this strategy doesn’t apply to you.
Here’s how it would look in a possible 2020 scenario:
- I start 2020 owning 1,000 shares of VCN at $34.00 per share.
- December 20th rolls around and VCN is now trading at $26.00 per share. (No, this is not a prediction!)
- I have lost $8.00-worth of value for each share that I own – totalling an $8,000 loss – which can be used to offset any gains.
- I login to my Questrade account to sell my shares, and “book” the loss.
- I take the $26,000 that I received in my discount brokerage account when I sold the 1,000 shares, and I use it to purchase XIC (which is a similar holding, but actually invests in a few dozen less small-cap stocks).
- I could also just sell it and take the risk that the market is going to go anywhere for 30 days, then re-buy my original VCN shares back again.
- I then sell my XIC shares 30 days later, and buy my VCN shares back.
To summarize, tax-loss selling is a strategy that can be great for investors who at one point picked an individual stock(s) or ETF that they thought would do well, yet after some time realized that they made a mistake, and would now like to sell it and move on. It’s also worth mentioning that for investors that want to keep their life super-simple, our Wealthsimple Review explains how Canada’s #1 robo advisor will actually complete this “tax loss harvesting” on your behalf once you have $100,000 in assets with the company.
However, the strategy can also be used effectively by index investors who have a large enough portfolio and a large enough loss in any given tax year to justify “booking” or “making real” a paper loss in their non-registered account in order to reduce their taxes owing. Our all in one ETFs article shows some excellent options for folks that like the idea of claiming a tax loss in their non-registered account, but also value overall simplicity. That said, remember to read the fine print when booking a transaction like this.
This guide was originally written by Frugal Trader, and updated for 2020 by Kornel Szrejber and Kyle Prevost.