Here’s what you need to know about tax and investing.
RRSP: Tax deferral
Money in an RRSP grows tax-free. You don’t have to fork over any money for gains or dividends (see below); whatever returns you earn, you get to keep. That is, until you withdraw your dough in retirement. All your hard-earned savings are taxed according to your income bracket when you pull the money out.
The idea is that you’ll be in a low tax bracket in retirement so you won’t have to pay that much. But these days, with people still working well into their 60s and 70s, some people will owe the CRA more than they had hoped.
TFSA: No tax
As you might guess by the name, your investments aren’t taxed in a tax-free savings account. You can sell whatever’s in there and not have to pay a cent in capital gains. There is a catch. Your TFSA room only grows by $5,000 a year, and that’s not enough for some big investors.
Capital gains: Taxed, but not by too much
It’s really people who own investments in non-registered accounts that have to worry about tax. Any investment that grows outside of an RRSP or TFSA is taxed when it’s sold. The growth is called capital gains. For instance, if you buy an investment for $100 and sell it for $200, you make a $100 gain. Fortunately, you’re not taxed on the entire amount. You only pay tax on half the gain and what you end up paying is based on your personal tax rate.
As an example, let’s say you’re in the highest tax bracket in Ontario and you have a $100 capital gain. You’ll end up paying 46 per cent tax on $50 (half the gain).
Capital gains taxes are also applied to property. If you sell a secondary residence for, say, $100,000 more than you bought it for (primary residences are not subject to capital gains taxes) and you’re in the highest tax bracket, you’d pay 46 per cent on $50,000. Canadian dividends: Favourable tax treatment
The Canadian government wants people to buy into Canadian companies, so they’ve given people a tax break on dividends paid by domestic businesses. The rate, as usual, depends on your income, but it can be between 15 and 24 per cent. Some people hold their dividend-paying investments outside of an RRSP because of the favourable tax treatment. Again, anything held inside an RRSP will eventually be taxed at an as-yet unknown-to-you rate, and the rate is usually higher than the dividend tax rate.
Bonds: Fully taxed
People like bonds because they pay an income. Every month or quarter, bond holders will get a cheque that they can do what they want with. However, those payments -- when held outside an RRSP or TFSA -- are taxed at your marginal rate. It’s no different than receiving a paychque from work. If you’re in the highest tax bracket, you’ll pay about 46 per cent on that income.
See why tax is such an important part of investing? When planning out a portfolio, take all of this into account so you don’t make any costly mistakes.
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