Making wise investment decisions is a challenging task that includes an important element-- tax planning. Understanding tax rules often plays a key role in determining what investments you buy and when you make transactions. Sometimes this can mean the difference between a winning and losing investment.
But once such tax-related decisions are made, there remains a crucial final step in the process -- ensuring the details are properly reported on your income-tax return so you can take full advantage of all deductions and credits related to your investment activity.
First, it is important to understand the difference between a tax deduction and a tax credit:
- A deduction reduces the amount of the income on which you pay tax, and thus is worth more to those with higher incomes.
- A credit is a direct reduction in tax. Some credits are "non-refundable," which means you can only claim the credit to the extent you have taxable income, whereas other credits are refundable, since you will pocket the amount even if your taxable income is zero.
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Here are several types of investment income and expenses that usually qualify for credits or deductions:
Dividend tax credit: Many publicly traded companies pay dividends to shareholders. They represent a share of corporate profits, and are taxed at a lower rate than interest and other income. The reasoning behind this is that corporations already have paid tax on these profits.
The net effect is that an Ontario investor who had taxable income of $60,000 in 2009, for example, pays tax on dividend income at a rate of only 6.9%, compared with 31.1% on fully taxable interest and other income, and 15.6% on capital gains. The amounts and differences in rates vary according to income level and province of residence. In Alberta, for 2009, dividends are taxed at 4.5%, compared with 32% on interest and 16% on capital gains.
The amount of tax payable on dividend income is calculated using an unusual calculation that requires "grossing up" the actual amount received by 45%, to reflect the amount of pre-tax income the corporation earned during the year. Then an offsetting 19% tax credit is calculated on the grossed-up amount. The result is claimed as a tax credit on your income-tax return.
Note that these dividend tax rates apply only to "eligible" dividends received by individual investors from Canadian public corporations and certain Canadian-controlled private corporations. Dividends paid by Canadian private corporations that are considered small businesses by the Canada Revenue Agency are taxed at a different rate.
Capital gains and losses: Many investors realize capital gains and/or losses on investments over the course of a year, and these must be reported on your income-tax return for the year in question. Note that we are talking about capital investments such as stocks, bonds or real estate that you actually sell, as opposed to an on-paper calculation of increases or decreases of an investment's value that have not been realized.
Tax must be paid on any profits realized from the sale of a capital investment. These amounts are taxed at a higher rate than eligible Canadian dividends, but less than at what interest income is taxed.
The tax break is created because only half of capital gains is taxable The amount of the gain is determined by subtracting the proceeds of the sale (net of the broker's sales commission or other disposition costs) from its adjusted cost base (ACB). The ACB consists of what you originally paid for it, plus the broker's sales commission or other acquisition costs.
Note that while capital-gains taxation rules also apply to mutual funds, there are some important differences when calculating the amount of the taxable gain. Moreover, there are different issues to consider regarding the sale of small-business shares, including access to a significant tax exemption. And remember that no capital-gains tax is payable on the sale of a principal residence.
Capital losses resulting from the sale of an investment may be used to offset the amount of capital gains in a particular year. However, if you did not realize any capital gains last year but did sell an investment at a loss, you can use it to reduce any capital gains that you reported during any of the previous three years, or save it indefinitely for use in a future year. Bear in mind that if you elect to apply losses to a prior year, the tax department must reopen your tax return for that year and do a reassessment.
Investment carrying charges: While brokerage fees are included in the calculation of a capital gain, there are other expenses related to owning an investment that can be deducted on an ongoing basis. Such expenses include interest paid on investment loans, fees paid on a safety-deposit box to store investment certificates, and investment management or counselling fees paid during the year.
Note that investment-loan interest is deductible only if you can prove there is a reasonable expectation of profit. This usually is not an issue when you borrow to buy stocks, but if you are doing so to invest in preferred shares, generally you can claim loan-interest costs only up to the amount of the grossed-up dividend rate. For loans taken out to purchase interest-bearing investments, the interest on these loans will be deductible only if the rate paid on the investment is higher than the rate paid on the loan. Interest charged on RRSP loans and administration fees paid for RRSPs and registered retirement income funds (RRIFs) are not deductible.
RRSP deduction: Contributions to a registered retirement saving plan are tax deductible. Subject to the annual contribution limits, you may deduct the total of any amounts put into a plan during the taxation year in question as well as during the first 60 days of the following year. For a 2009 deduction, the amounts must have been put into your plan between Jan. 1, 2009, and March 1, 2010 inclusive.
However, if you had a low-income year and thus have relatively low RRSP deduction room, and you would prefer to save this deduction for a future higher-earning year, you can elect to not defer to future years the use of these contributions as a deduction. Note that you would have to have enough RRSP deduction room in future years to use this un-deducted amount.
