What is investment income?

Beyond your regular paycheque, there are many ways to grow your wealth. Investment income is one of them. This type of income refers to the financial returns generated from assets such as stocks, bonds, mutual funds, exchange-traded funds (ETFs) and real estate. It can take various forms, including interest, foreign income, dividends, distributions (mutual fund and ETF) and return of capital. Understanding how each of these works is key to making informed financial decisions and optimizing your overall strategy.

Like your paycheque, investment income is also subject to taxation by the Canadian Revenue Agency (CRA). What you owe will depend on several factors, such as your marginal tax rate, how you generate the investment income and where your assets are held.

Here’s a breakdown of the main types of investment income and how each one can affect your taxes.

Comparing investment income types

Interest and foreign income

Just as you pay interest on a mortgage or a bank loan, you can also be on the receiving end of those payments when you buy assets like treasury bills, guaranteed investment certificates (GICs) and bonds. The money you put toward these assets acts as a loan to the financial institution, and it is required to pay you interest on the amount in return. If you hold foreign stocks, bonds, mutual funds or ETFs with foreign investments, you will earn foreign income on those investments. The interest and foreign income generated by these assets is taxed as ordinary income, meaning they are fully taxable at your marginal rate.

Canadian dividends

Dividends are payments made to shareholders of a stock, mutual fund or ETF. The payment typically comes out of company earnings and is a percentage of the value of the shares held. Depending on the company, you may receive dividend payments monthly, quarterly, semi-annually or annually.

There are two types of dividends paid by Canadian corporations.

Eligible dividends

These are funds paid by Canadian public or private corporations and are paid out of a company’s income that has been taxed at the general corporate tax rate. Dividends paid by eligible Canadian corporations receive more favourable tax treatment, because the company has already paid tax on this income at the higher general corporate rate.

Non-eligible dividends

These dividends are paid by companies that are subject to a lower corporate tax rate, which generally include privately held small businesses. Because the company has paid tax at a lower rate, this results in a higher tax rate for the investor.

Both eligible and non-eligible dividends will be taxed based on the province or territory where you live and your marginal tax rate. If the dividends are generated in a non-registered account, you will receive a T3 Statement of Trust Income Allocation and Designations or a T5 Statement of Investment Income slip, which will indicate whether your dividend is eligible or non-eligible. In the hierarchy of tax treatment for investment income, dividends get preferential treatment to interest and foreign income.

Distributions

Similar to dividends, distributions are investment income paid out by mutual funds or ETFs. They can include income from interest, foreign income, capital gains or dividends earned by the fund’s underlaying investments and are paid to unitholders. If you hold either of these assets outside of a registered account, you will have to pay tax related to each income source at your marginal rates.

Mutual fund and ETF distributions can also be reinvested to purchase additional units of the fund. While you’ll still have to pay tax on these reinvested amounts in the year you receive them, they are added to your adjusted cost base (ACB). This increases your cost base, so when you eventually sell the units, any capital gain is reduced accordingly, ensuring the same income isn’t taxed twice.

Capital gains

Any time you sell an investment for more than you paid for it, you earn a capital gain. In terms of tax efficiency, capital gains are at the top of the list. Only half of your capital gain is subject to tax, with the balance being taxed at your marginal rate. For instance, only $500 of a $1,000 capital gain would be subject to tax. If your marginal rate was, say, 26%, then you’d owe $130.

Return of capital

Return of capital (ROC) is not taxed, because you’re simply getting back part of your original investment. However, an ROC reduces the ACB of your investment, which means you may have a larger capital gain and owe more tax later when you eventually sell your investment.

For example, if you invest $1,000 in a fund and it distributes $400 as a ROC, your ACB would drop to $600. If you later sell the investment for $1,100, your capital gain would be the difference between the selling price and the ACB (or $1,100 - $600). Over time, ROC distributions will steadily reduce your ACB.

Still, ROC distributions can be beneficial if your goal is to minimize your taxable investment income while holding that investment. For instance, ROC may be advantageous to investors who are close to the limit for income-tested benefits, such as Old Age Security (OAS), because it could prevent or limit a clawback of those benefits.

The Upside^TM

Tax strategies to maximize your investment income

Shelter your investment income in tax-advantaged accounts – One of the most effective strategies to manage the amount of tax you owe on your investment income is to hold your assets and securities in a registered account, such as a Registered Retirement Savings Plan (RRSP), Tax-Free Savings Account (TFSA) or First Home Savings Account (FHSA). This allows your money to grow tax-deferred or tax-free, meaning you won’t pay tax on investment income generated in these accounts while your assets remain there. In some cases, like holding U.S. dividends in a TFSA, foreign withholding tax may still apply.

Maximize your registered account contributions – Depending on your investment goals, you may consider maximizing your contributions to your registered accounts before investing in a non-registered account. That’s because you’re required to pay tax on any investment income earned on assets in non-registered accounts. However, contributions to RRSPs and FHSAs are tax-deductible. For non-registered investing, tax efficiency becomes even more important and requires some strategic thinking.

Consider reinvesting dividends – You can consider reinvesting dividends to help reduce your taxable income and boost your savings. As previously mentioned, registered accounts allow your money to grow tax-deferred or tax-free, which also extends to any amounts reinvested. For non-registered accounts, you won’t receive immediate tax relief by reinvesting dividends, but you may benefit from tax-efficient growth over time, thanks to compounding.

Optimize your portfolios – If you’re looking to optimize your portfolio, holding tax-efficient assets, such as Fidelity’s Tax-Smart Solutions, may be the right move for you.

While taxes aren’t the only consideration when building and maintaining an investment plan, understanding the difference between types of investment income and how they are taxed can help you make more informed decisions about your investment strategy. When in doubt, a financial advisor can help you choose the right mix for your goals and implement tax-efficient strategies, so you keep more of what you earn.