This post is about understanding income taxes enough to know how they impact saving, investment and retirement income. Income tax is a very complex subject and this post will NOT be a complete summary of all the income tax laws and rules (in Canada). This post will attempt to summarize just what you need to know for saving and investing, provide links to additional references (if you wish to read more) and also links to tools to help understand the quantitative impact of income taxes.
If you are not familiar with the origins and purpose of income tax you should read the Wikipedia entry on the subject Wikipedia: Income Tax. Pay attention to the sections "Defining Income" and "Deductions Allowed" as these are important concepts when considering saving and investing as not all types of income are taxed in the same manner, some contributions to savings (ie RRSP) are deductions and some investment income (ie dividends) are allowed tax credits against taxes.
The concepts of income tax are actually quite simple. The details behind the rules, especially when governments try to encourage one activity over another, can become quite extensive and complex. However, even with relatively simple tax rules, the impact of taxes on what decisions you should make regarding saving and investment can be quite difficult to calculate.
I see many blog articles trying to provide advice on the best saving and investment strategy. Typical subjects are whether to put money into your mortgage, RRSP or TFSA (assuming you can't fund all simultaneously). The best strategy sometimes depends on your particular situation so you may have to calculate this for yourself. Understanding taxes is key to determining what is best, I will provide some guidance of the best strategies based on generic situations, but I will also provide you the tools to calculate this yourself and show you how.
In Canada income taxes are payable to both the Canadian government and the government of the province you reside in. There is quite a variability in tax rates and tax credits between the various provinces so amount of tax payable can vary considerably among the provinces.
First lets look at the federal (Canadian) tax tables. The 2014 income tax rate for different levels of income are shown in the following table.
| Income range | Marginal Tax Rate | Tax Payable |
| up to 43,953 | 15% | 15% of income |
| 43,953 to 87,907 | 22% | 6,593 + 22% of income over 43,953 |
| 87,907 to 136,270 | 26% | 16,263 + 26% of income over 87,907 |
| over 136,270 | 29% | 28,837 + 29% of income over 136,270 |
The equivalent table for the province of Ontario is shown below.
| Income range | Marginal Tax Rate | Tax Payable |
| up to 40,120 | 5.05% | 5.05% of income |
| 40,120 to 80,242 | 9.15% | 2,026 + 9.15% of income over 40,120 |
| 80,242 to 514,090 | 11.16% | 5,697 + 11.16% of income over 80,242 |
| over 514,090 | 13.16% | 54,115 + 13.16% of income over 514,090 |
If you want to calculate how much tax you will pay for different income levels, the best way is to use one of many calculators available. This one at TaxTips.ca is very good: TaxTips Basic Calculator Try it out by putting in an income amount in the "Employment & Other Income" box and see the tax payable for the different provinces. You should get results like the image below.
In order to get to the amount of income tax let's back up a little and discuss income, deductions and tax credits.
Income is generally your employment income, income from investments and income from pensions. For consideration of saving and investing we must understand how different incomes are taxed.
- The following are considered income that is fully taxable:
- Employment income
- Pension income from an employers DB (defined benefit) pension plan
- Interest income from investments
- Dividend income from non-Canadian sources
- Withdrawals from RRSP accounts
- Withdrawals or income from a LIF or RRIF account
- CPP (Canada Pension Plan) income
- OAS (Old Age Security) pension income
- Only a portion of Capital Gains are taxed. The current inclusion rate is 50% so that effectively income from gains are only taxed half as much as income. Capital losses are not a deduction from income but can only be used as a credit against capital gains.
- Dividend income from most Canadian corporations is considered "eligible Canadian dividends" and receives favourable tax treatment. The dividend amount is actually "grossed up" or increased by 38% increasing your taxable income, but also receives a significant tax credit.
- Dividend income from non-eligible sources (still Canadian sources) is taxed more than the eligible dividends, but is still lower than employment income and in most cases less than capital gains.
- The following are NOT considered income for tax purposes (and are therefore not taxed)
- Any interest, dividends or gains from investments in a TFSA account.
- Withdrawals from a TFSA account.
- Any interest, dividends or gains from investments in an RRSP account, LIRA account or a DCPP (defined contribution pension plan). Note that these are taxable when withdrawn.
Deductions are very important when you are doing your taxes. You want to make sure you identify all the possible deductions you can take to minimize your taxes. From the standpoint of understanding savings and investment there is only one that we need to consider.
Contributions to an RRSP account are considered as deduction from taxable income, so not tax is paid on that income you direct to the RRSP. If you have enough income to be paying taxes, the money you put into the RRSP will save you taxes.
Tax Credits
Tax Credits are usually described as non-refundable tax credits. The one that everyone gets is the "Basic Personal Amount" which is about $11,000 for federal tax. The federal tax credit rate is 15% so the actual credit to taxes is 15% of $11,000 or $1,650. You would have noticed that the lowest federal income tax rate is also 15%, so you could earn up to $11,000 and still pay no tax as the credit offsets the tax on income. There are other credits available depending on your situation so the income level you can earn and still pay no tax might be higher. For provincial taxes the "Basic Amount" varies considerably by province so the individual can earn between $7,000 and $17,000 before paying any provincial tax.
The most important tax credit considering saving and investing is the tax credit for Dividend income. This tax credit makes the effective tax rate for dividend income lower than employment income and usually lower than for capital gains.
More on Dividends
Because of the tax credit the effective tax rate on dividend income can be quite low. The best way to see this is use the TaxTips basic calculator (click image below). Put in some dividend income and see what the tax rate is calculated at. If you put in only $50,000 of eligible dividend income, then in more than half the provinces you will pay no tax at all.
How does income tax work for dividends? For "eligible" Canadian dividends, the actual amount of dividend received is grossed up by adding 38% and this becomes your taxable income. Calculate tax payable (before credits) on your entire income using the tax tables. The dividend tax credit is the taxable amount of dividends times 15.02%, the federal dividend tax credit rate, then subtract this from the taxes payable. So if you are in the 15% tax bracket, under about $44,000, then the dividend tax credit cancels out the tax payable. If you use TaxTips basic calculator you will see that you can earn up to $50,000 of dividends (with no other income) and pay no federal income tax.
The reason behind the advantageous tax rate for dividends is that dividends are paid out by corporations to the investor after corporate taxes have been paid. Therefore, if dividend payments were fully taxed in the hands of the investor, it would equate to a double taxation.
Non-eligible dividends do not get quite the same tax advantage as the Eligible dividends. The gross-up of non-eligible dividends is 18% and the federal dividend tax credit rate is 11.017%. The dividend tax credit rates also vary considerably by province.
Again, if this seems confusing, use the TaxTips.ca basic calculator and see how much you will pay on various amount of dividend income.
Summary
Let's summarize what we have covered so far.
- Capital gains are taxed half as much as regular income. In most cases dividends are taxed even less than capital gains.
- Growth of RRSP and TFSA and withdrawals from TFSA are not taxed at all. So to minimize taxes on investment income you would rather use a TFSA or an RRSP in preference to a taxable account.
- In a taxable account you would favour dividends and capital gains over regular interest income and dividends from non-Canadian sources.
One other really important point to consider is that capital gains are only taxed when you realize the gain (sell the investment). Dividend and interest income are taxed in the year they are received, but taxes on capital gains are deferred until you sell the investment, which means the investment can grow tax free until you need to sell it (for retirement income). In a later post I will address how much difference this makes.
Some ideas for future posts:
- Which is better TFSA vs RRSP (assuming you can't fund both).
- Pay off Mortgage vs Investments.
- Capital gains vs Dividends. Does the deferring of taxes from gains beat the lower tax rate from Dividends?
Disclaimer: These posts are not fully comprehensive financial advice. You should seek your own qualified investment, tax and legal advice.
This blog post is, as the young kids say these days, "On Fleek"!
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