Investor tax tips for 2020

With the fuss of the yuletide holiday season firmly in your rear-view mirror and now most people hunkered down for mid-winter, it’s the right time to look down the road – in some cases, quite far – to assess your financial affairs and in particular review tax-planning strategies. Doing so can not only potentially reduce the amount of income tax you pay, it can help navigate the best route for your financial future.

How much income tax we pay depends on a variety of factors including employment, investments, marital status, homeownership, retirement, and even how our affairs are organized for when we die.

Map out your tax payouts
Evaluating an investment according to its potential for appreciation and your risk tolerance is essential. But how these investments will be taxed is another important consideration. Virtually all investments will produce one or more of the three types of income: interest, dividends or capital gains. Within each of these there can be twists, depending on when income is paid to you (in the eyes of the taxman) and the nature of the source (in terms of geography and the type of institution in which you’ve invested).

Interest
Amounts of interest received from term deposits, bonds and other interest-bearing investments are fully taxed at your top marginal tax rate. There are no credits or deductions claimable on your income tax return. For example, interest received in 2020 by an Ontario taxpayer with taxable income of $100,000 would be taxed at rate of 43.4%. The same taxpayer in B.C. or Quebec would be taxed 38.3% and 45.7% respectively. Note that, on investments with a term of greater than one year, you must report accrued interest annually. This is the amount of interest earned (but not actually received by you) as of the anniversary of the investment’s purchase date. If you make a short-term interest-bearing investment early in 2021 instead of late 2020, you will defer having to pay tax on the earned interest by a year.

Dividends
Dividends are taxed more favourably than interest, thanks to the dividend tax credit. This is especially so for “eligible” dividends – those received from a Canadian corporation (including publicly traded or, in some cases, private entities). The tax break is less lucrative for non-eligible dividends, which are those received corporations from that pay tax at the small-business rate. Foreign-source dividends are taxed at your top marginal rate. For a $100,000 earner in Ontario, eligible dividends would be taxed at 25.4% in 2020, while in B.C. and Quebec the rates are 15.5% and 29.6%. On non-eligible dividends, the tax rates in those provinces are 36.1%, 31.4% and 38.4% respectively.

Capital gains
Only one-half of capital gains are taxable, and only when an investment is actually sold. This applies to all forms of capital property – securities, real estate (except a principal residence, the sale of which is tax-exempt) and personal-use property. For example, a $20,000 profit resulting from the sale of a stock would produce a taxable gain of $10,000, on which you pay tax at your top marginal rate. Using the above taxpayer examples, this would result in capital gains being taxed at 21.7%, 19.2% and 22.9% in those respective provinces. Note that any income defined as return of capital is not taxable, as it is simply a portion of your original investment being returned to you.

But capital gains aren’t always the most lightly taxed form of investment income. The wide disparity among individual provinces’ tax brackets and corresponding rates will determine the relative favorability, depending on your taxable income. Generally, investors with relatively high taxable incomes will pay less tax on capital gains than on dividends, while the opposite is true for those in lower brackets. For example, the Ontario investor with $100,000 in taxable income will pay tax on capital gains at 21.7% compared with 25.4% on eligible dividend income. The gap is greater for a $200,000 taxpayer, 24% versus 31.7%. The thresholds at which the balance is tipped in favour of capital gains varies considerably among provinces. In Ontario, this occurs for those with taxable income of over $97,069. In B.C., the threshold is much higher, at $150,473. In Quebec, however, it is just $89,080.

Mutual funds
Income from a mutual fund trust is taxed in much the same way. Almost all mutual funds are structured as trusts and thus are required to flow all forms of income through to their investors. A fund company will issue a T3 slip that specifies amounts of dividends and interest that must be reported on your tax return and on which tax must be paid at the above-mentioned rates. You will also see a box indicating capital-gains dividends; this amount is to be reported not as dividend income but as a capital gain. This figure represents the cumulative amount of gains and losses incurred in a fund’s portfolio. This process is separate from when you sell units of a fund, when you pay capital gains tax on the proceeds – less the amount of tax paid in respect of capital gains dividends already received from that fund.

Mutual-fund corporations (as opposed to trusts) only distribute capital gains and Canadian dividends; all other income earned by the fund in excess of expenses is retained within the corporation taxed at the corporate rate. For more on taxation of mutual fund taxation, go to How mutual fund income is taxed.

RRSPs and TFSAs
In addition to considering taxation rates when managing your investment portfolio, before the new year progresses, consider contributing as much as possible to a registered retirement savings plan and/or tax-free savings account. This will allow you to get your savings working for you in a tax-deferred (RRSP) or tax-free (TFSA) environment as soon as possible, rather than waiting until the traditional deadlines of 60 days after year-end (RRSP) and year-end (TFSA).

Remember that both schemes allow you to accumulate unused contribution amounts, so be sure to take advantage of any contribution room to the extent you are able. The annual RRSP contribution limit (excluding any available contribution room) for 2020 is $27,230, up from $26,500 for 2019. (The deadline for making an RRSP contribution that is deductible on our 2019 tax return is Feb. 29, 2020.) The 2020 TFSA annual contribution limit is $6,000. If you have never contributed to a TFSA, as of this year you have accumulated $69,500 in contribution room.

While it is important to invest for long-term growth within tax-advantaged savings plans, a basic rule of thumb is to hold more highly taxed investments within an RRSP or TFSA.

Income splitting
As well, don’t overlook the benefits of income splitting. For starters, you can transfer dividend income from a low-income spouse who pays little or no tax to the higher-income spouse, allowing the latter to potentially gain from the tax credit. Looking to the future, a spousal RRSP offers an effective form of income splitting after retirement. You are allowed to contribute to your spouse’s RRSP, up to your cumulative limit, and claim the deduction on your own tax return. This strategy is intended to provide more equal flows of income post-retirement, thus resulting in a lower tax bill for what would otherwise have been a much higher income spouse.

Broader forms of income splitting basically allow a high-income spouse or parent to pay salaries or lend money to immediate-family members, thereby moving income to a lower-taxed environment. However, all income-splitting strategies must be realistic and properly structured, lest they risk being disallowed under the tax department’s income-attribution rules or other anti-tax-avoidance regulations.