One of the key benefits of investing is that you (usually) receive some sort of investment income. Most people will eventually move from growing their investments to drawing from them, so they’ll need those investments to provide them with income.
In general, there are five main types of investment income:
- Interest income.
- Dividend income.
- Capital gains.
- Return of capital.
- Rental income.
In this article, we’ll take a close look at each type of investment income and how they’re taxed. There can be a significant difference in the taxation rate of different investment income sources, so it’s important to understand how much each investment type is likely to provide in the way of after-tax income.
Interest income
When you put money into a savings account or similar (such as a guaranteed investment certificate), you’re essentially lending that money to the bank or other borrower and allowing them to use it for their own purposes. You’ll then typically earn income in the form of interest (as a percentage of the loaned amount).
Assets that provide interest income are often referred to as fixed income investments and are usually considered conservative or safe options. They include:
- Savings accounts.
- Guaranteed investment certificates (GICs).
- Bonds (these could be government bonds, from federal, provincial or municipal governments, or corporate bonds, which are issued by large companies).
- Bond mutual funds or exchange-traded funds (ETFs).
Savings accounts normally provide the lowest income on interest of any of these types of investments (even so-called high-interest savings accounts). However, they do offer higher interest rates when the Bank of Canada’s overnight rate is high (as when it peaked at 5% from July 2023 to June 2024).
When the overnight rate is high, savings accounts have provided interest rates as high as 5% and above. When the overnight rate is low, however (such as during the COVID-19 pandemic, when it was at 0.5%) savings accounts often pay even less than 1% in interest.
GICs usually offer somewhat higher interest rates, and bonds (particularly corporate bonds) can sometimes deliver the highest interest rates of these three investment options.
Of all sources of investment income, interest income is the least tax efficient. It’s taxed at the same rate as the earnings in your paycheque (no matter if the source of the interest is from within or outside of Canada). Interest income is fully taxable at your marginal tax rate, meaning it’s taxed at the highest rate compared to other types of investment income. For example, in Ontario, the applicable rate could be as much as 53.53% if your income is in the highest earning bracket.
Dividend income
Most large companies whose shares are traded on stock exchanges pay investment income to their shareholders in the form of dividends. This is usually a percentage of the value of shares held, and payments can be made monthly, quarterly, semi-annually or annually, depending on the company.
The percentage of the dividend can vary greatly from company to company. Some pay out as little as 1.5%, while others pay out dividends of 7% and even higher. Typically, you can take dividend payments and use them as income or reinvest them.
Investment income from dividends is taxed at a lower rate than interest income, but in Canada, this is a somewhat complex issue. You could own investments in dividend-paying companies in Canada, the U.S. and other international companies, and taxation rules are different for each one.
For Canadian dividend investment income, there are two tax levels. One is for eligible Canadian dividends and the other for non-eligible Canadian dividends. Eligible dividends are usually paid by publicly traded Canadian companies whose income is taxed at a higher corporate rate. Non-eligible Canadian dividends are usually paid out by private corporations that have a lower corporate tax rate.
Both Canadian dividend income options have typically lower tax rates for investors than interest income, due to the federal dividend tax credit that’s designed to provide relief from double taxation. Using the Ontario rates to put this into perspective, the highest marginal tax rates are 39.34% for eligible dividends and 47.74% for non-eligible dividends.
Unlike Canadian dividends, foreign dividends do not qualify for the federal dividend tax credit. This means they’re taxed at a higher rate, similar to interest income. Many countries impose a withholding tax (15% - 25%) on dividends paid to non-residents. If you paid foreign taxes on your dividends, you might be eligible to claim a foreign tax credit (similar to interest income) on your Canadian tax return. This credit can help reduce the amount of Canadian tax payable by the amount of foreign tax paid.
For dividend income from U.S. companies, if you hold these stocks in an RRSP or a RRIF, there will be no withholding tax charged (this is due to the Canada-U.S. Tax Treaty). Otherwise, these dividends will be subject to a 15% withholding tax.
It’s worth pointing out, however, that some of the biggest companies don’t pay dividends. Investors buy shares in these companies because they have historically grown fast and provided returns in the form of capital gains.
Capital gains income
When you buy a capital asset, such as a mutual fund or shares in a company, then sell it at a profit, you’ll realize what is called a capital gain. Capital gains can also occur if a portfolio manager of a mutual fund you’ve invested in sells some of the shares within it at a profit.
When you invest in the stock market over a long period of time, capital gains can provide a large percentage of your investment income. There is a tax advantage to capital gains as a source of investment income. As of June 25, 2024, the proposed inclusion rate for individuals is 50% on the first $250,000 of capital gains and 66.67% on any amount exceeding $250,000. This means that only half or two-thirds of your capital gain is subject to tax, depending on the total amount. At the time of writing, though, this proposal had not yet become law.
The taxable portion of your capital gain is added to your other income and taxed at your marginal tax rate. This rate varies based on your total income and the province or territory where you live. Going back to the Ontario tax rate example, the highest rate of tax for capital gains is 26.76%; considerably less than tax rates for dividend and interest income.
Capital gains are only taxed when you sell the asset. Unrealized gains (where you still hold the asset) are not taxed. You can offset capital gains with capital losses to reduce your taxable income, and, alternatively, if your losses exceed your gains, you can carry the losses back three years or forward indefinitely to offset future gains.
Return of capital
When you invest money, the amount you contribute is known as the principal (also known as the adjusted cost base). When you withdraw this portion of your savings (as opposed to capital gains, dividends or interest) this is known as the return of capital (because it is the money you originally put into the investment that is being returned to you).
Some investment products (such as Series T of IG’s iProfile and IG Income Portfolios) allow you to withdraw part of your principal payment, which reduces the adjusted cost base of your investment. Return of capital can be a tax-efficient way to receive distributions, as it defers tax until the investment is sold. Return of capital is not classified as earned income, so you’ll not be taxed on that money when you withdraw it (unlike with capital gains, dividends and interest). Note however, that this only applies to non-registered investments (those that are not held in government-registered accounts, such as RRSPs and RRIFs).
Having part of your investment income as a return of capital will not only potentially reduce your tax bill, it can also help reduce your total annual income so that you remain below the income threshold for certain benefits, such as Old Age Security, and therefore avoid having to pay back some of that benefit.
Note that when you do eventually sell the investment, the reduced adjusted cost base could result in a higher capital gain or a smaller capital loss. If the return of capital reduces your adjusted cost base to below zero, the negative amount is considered a capital gain in the year it occurs.
Property rental income
If you own rental properties, this kind of investment income is treated as taxable, at your marginal tax rate. You can, however, claim certain expenses to reduce the total amount of rental income. These expenses include:
- Utilities.
- Municipal property taxes.
- Insurance.
- Repairs and maintenance.
- Professional fees.
You can find out more about tax on property rental income here.
How to minimize tax on your investment income
There are several government registered accounts that allow you to invest and grow your money tax-free or tax-deferred. These include:
- Registered Retirement Savings Plan (RRSP)
- Registered Retirement Income Fund (RRIF)
- Tax-Free Savings Account (TFSA)
- First Home Savings Account (FHSA)
- Registered Education Savings Plan (RESP)
- Registered Disability Savings Plan (RDSP)
No matter what investment income you earn on these accounts, you won’t be charged a cent in tax while those assets stay in the registered account (and, in the case of an RRSP, they’re not taxed when they’re transferred to a RRIF either).
With an RRSP and a RRIF, withdrawls are fully taxable as income at your marginal tax rate. RESPs and RDSPs include government grants and investment earnings, and are taxable in the hands of the student (for RESPs) or the beneficiary (for RDSPs). It’s important to note that the original contributions to an RESP or RDSP are not taxable when withdrawn. In some provinces, withdrawing from an RDSP may affect the amount of provincial benefits you receive. It's important to check with your provincial government to understand how your benefits might be impacted.
With a TFSA and FHSA, you don’t pay tax on withdrawals, so you get to enjoy investment income that is completely tax free (as long as you use your FHSA proceeds to buy your first home and meet all the conditions for a qualifying withdrawal).
Consequently, it makes a lot of sense to keep as much of your savings as possible in registered accounts to grow that money tax-efficiently.
Getting started with optimizing investment income
It’s really important to have comprehensive financial advice before investing in any assets. An IG Advisor can build a tailor-made investment strategy to fit your particular needs, using only the kinds of registered accounts that suit your circumstances and financial goals.
They’ll provide you with professional management to select the right income-generating investments, diversify your portfolio with various sources of income, and continually adjust your portfolio to maximize growth while managing risk.
Talk to your IG Advisor today about the best investment income options for you. If you don’t have an IG Advisor, you can find one here.
Written and published by IG Wealth Management as a general source of information only. Not intended as a solicitation to buy or sell specific investments, or to provide tax, legal or investment advice. Seek advice on your specific circumstances from an IG Wealth Management Advisor.
GICs issued by Investors Group Trust Co Ltd., and/or other non-affiliated GIC issuers. The Canada Disability Savings Grant and the Canada Disability Savings Bond are provided by the Government of Canada. Eligibility depends on family income levels.
Commissions, fees and expenses may be associated with mutual fund investments and the use of iProfileTM Managed Asset Program. Read the prospectus and speak to an IG Advisor before investing. Mutual funds are not guaranteed, values change frequently and past performance may not be repeated. An asset allocation service, iProfile is a managed asset program for clients with a minimum of $250,000 invested in the iProfile program. Mutual funds and investment products and services are offered through Investors Group Financial Services Inc. (in Québec, a Financial Services firm). And Additional investment products and brokerage services are offered through Investors Group Securities Inc. (in Québec, a firm in Financial Planning). Investors Group Securities Inc. is a member of the Canadian Investor Protection Fund.
