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Types of Income and the Tax Impact
For many people, investment income ends up being taxed at the highest marginal rate. To put more after-tax investment dollars in your pocket, it is important to understand how taxes affect different types of investment income which include: Interest Income, Dividends and Capital Gains.
Each dollar of interest income you earn is fully taxable at your marginal tax rate. From a tax point of view, interest is the least attractive way to receive investment returns in a non-sheltered (non-registered) portfolio.
Calculating tax on interest income is straightforward: simply apply the marginal tax rate to the income earned.
In the top marginal tax bracket, approximately half an investor's gain is eliminated after taxes. For investors with both regular and registered (RRSP or RRIF) portfolios, it may be preferable to accumulate interest income in the tax sheltered environment of your RRSP/RRIF, and concentrate on dividends and capital gains as part of your non-RRSP investing. Naturally, your own individual investment objectives will determine the actual asset mix in your investment portfolios.
The tax system recognizes that dividends are paid out of income on which the corporation has already paid income tax. To compensate, dividends of Canadian taxable corporations are subject to gross up/dividend tax credit treatment.
The net effect is a reduction in the personal tax owing on the dividend income.
A capital gain arises when you purchase a security or other capital property (generally real estate, art, collectible, etc.) at one price and sell it for more than you paid. The difference, less any transaction costs, is the capital gain. Alternatively, a capital loss would result from buying a capital property at one price and selling it at a lower price.
One-half (50%) of any net capital gains (capital gains less capital losses) are subject to tax at your marginal tax rate.
If $1,500 of capital gains and $500 of capital losses are realized by an Ontario investor in the highest tax bracket (with a marginal rate of 53.5%), the investor would pay approximately $268 in tax.
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