Income is a broad term in the world of taxation. Basically, it includes all incoming money that makes up the amount on which you may have to pay income tax.
However, “income” for living purposes usually means what you have coming in from various sources that fund your lifestyle. During one’s working years, this is likely almost entirely salary, wages, or business or professional income. After retirement, however, it’s what you can take in from pensions and investments. Rather than rely on periodic sales of securities to produce capital gains, many retirees structure their investment portfolio to provide a reliable stream of income. This generally is in the form of interest (such as from bonds and cash deposits) and dividends (from equity investments). It can come directly from these securities, or via mutual funds structured to produce regular income payouts.
Tax-saving strategies represent an important part of wealth accumulation and retirement planning, says Joseph Micallef, national tax leader of financial services with KPMG in Canada. “This involves understanding how – and when – various types of income are taxed in order to determine the types of investment accounts (taxable versus tax-deferred versus tax-free) in which they should be held. For example, interest income is fully taxable on an accrued basis, even though it might not have actually been paid out to you. Dividends, on the other hand, are taxed only when received, and those paid by a Canadian company can benefit from a tax credit when received by an individual.”
You must also determine which types of investments should be held in a taxable account, as opposed to a tax-deferred plan, such as a registered retirement saving plan (RRSP) or registered retirement income fund (RRIF), or in a tax-free savings account (TFSA). “Knowing when to draw down income from various sources during retirement is important to maximize your tax efficiently and minimize the impact of the Old Age Security clawback and/or giving rise to alternative minimum tax,” Micallef says.
Interest Income Tax Tips
Interest earned in Canadian bank or brokerage accounts, or on short-term deposits as well as debt instruments, generally results in a T5 tax information slip (plus a Relevé 3 for Québec residents) being issued to you by the institution involved. All interest income earned (from both domestic and foreign sources) must be reported on your tax return on an accrued basis even if it has not been paid to you during the year.
For more on taxation of interest income, see Canadians: Consider the Tax on the Interest You Collect.
Dividend Tax Tips
Dividends paid to you by Canadian corporations are taxed at a lower rate than interest income, thanks to the dividend tax credit. “Eligible” dividends -- those paid out by Canadian public corporations and certain Canadian-controlled private corporations (CCPCs) – receive the most favourable treatment. The tax credit is calculated by first “grossing up” by 38% the actual amount received and then applying a tax credit, which varies according to province. In Ontario, dividends are taxed at an effective rate of 39.34% for a taxpayer in the top tax bracket. Eligible dividends for top-income residents in British Columbia have an effective tax rate of 36.54%, while in Quebec the top rate is 40.11% and in Alberta 34.31%.
“Non-eligible” Canadian-source dividends generally are those paid by incorporated small businesses and have a higher effective tax rate. These dividends are classified as non-eligible where a dividend has been paid out of income that was previously taxed at lower tax rates that are available to small-business corporations. In Ontario, for example, a top-bracket taxpayer would pay a tax of 47.74% on non-eligible dividends.
Foreign-source dividends do not benefit from the dividend tax credit and are fully taxed only when received. However, where foreign withholding taxes were paid on dividends received, a foreign tax credit can be used to reduce Canadian taxes. Foreign corporations generally do not provide Canadian tax slips, so it is important to review and reconcile your income against your investment account statements.
While most dividends today are from common shares, some companies issue preferred shares. “Preferred shares generally have a fixed dividend rate and certain other features which can seem very similar to fixed-income investments -- but with the tax advantage of a lower tax rate than interest where the dividend is also eligible for the dividend tax credit,” Micallef says.
If you receive dividends in the form of newly issued shares of the company, rather than as cash, the value of these shares is still considered dividend income and taxed as such. Private corporations sometimes pay capital dividends, which represent the untaxed, one-half portion of capital gains realized by the corporation. You, the investor, are not taxed on this income.
Dividends and Income Splitting
Dividend income can represent an income-splitting opportunity. Since the dividend tax credit is a non-refundable credit, you may transfer dividends to your spouse (or vice versa) if you or he/she has no income to be offset by it. While this can reduce the amount of the spousal tax credit for the higher-income spouse, you can elect to report your spouse’s dividend income on your own tax return, thus preserving the spousal tax credit. Quebec taxpayers do not make this election on their provincial tax return, as there is a broad provision to claim the unused portion of their spouse’s non-refundable tax credits.
Mutual Fund Tax Tips
While most equity mutual funds are designed to create capital growth, several have mandates that focus on providing an income stream to their unitholders, usually in the form of dividends or interest from the investments in their portfolios.
“Whether an investor chooses to receive the income from the fund or reinvests it back into the fund for additional units, if the fund is held in a taxable account, you would need to include such income for tax purposes,” Micallef says. “However, if an investor chooses to re-reinvest any distributions from a fund, the income which has already been included for tax purposes would be added to the cost base of the additional units received in order to avoid double-taxation when such units of the funds are sold.”
Tax-Advantaged or Taxable Account?
There are several considerations when deciding whether to hold a particular investment in a taxable account, or in a RRSP/RRIF or TFSA. “These include whether savings are needed in the short term or long term, a person’s available contribution room, the number of years until retirement, and other lifestyle factors,” Micallef says.
Under straightforward circumstances, investment returns or income that benefit from tax credits, deductions or exemptions would be held in taxable accounts, Micallef says. “However, investments that are higher taxed, such as foreign or interest income, would be held in tax-deferred or tax-free accounts, since the amount of tax paid is deferred until some point in the future and when drawn upon by an individual they may be in a lower tax bracket.
“Remember, though, that no one size fits all and thus it is important to consult a financial advisor in order to help determine the types of investments and investment accounts you should consider in your overall portfolio construction and management.”
