How Taxes Affect Your Income and Investments
Part 2 of 2-Part Series
This blog is a continuation of the previous piece which discusses taxes and our income streams. Part 1 explores the very basic understand of the different kinds of income and a general Canadian tax structure. Part 2 now dives into the details.
The taxes which come off our pay cheques are employment income taxes and the tax rate or percentage is based on how much income you earn each year inclusive of all your income streams. If you live in Toronto, Ontario and earned a salary of $75,000 in 2020 working for the ‘man’ (or women!), the combination of federal and provincial taxes you pay to the government will be $15,025. There are of course tax deductions and credits, but for the scope of this article we won’t get into that. The takeaway is that 100% of your employment income is taxable.
Interest income is actually taxed the exact same way as employment income, and 100% taxable. If you earned $75,000 off of your interest investments in 2020, living in Toronto, Canada, you’ll be paying the exact same tax amount as if you earned it from a job. Of course, if you worked that 75K job and earned 75K from you interest investment, then your total income is 150K and your taxes are going way up!
Capital gains taxes are much easier on our wallets, taxed at a 50% inclusion rate. Say you bought and sold a house this year and made a profit of $75,000, the amount eligible for taxes would only be $37,500. This means not only are you paying taxes on a much lower amount, half of what would be taxed if it were employment or interest income, but you’re also in a lower tax bracket! The total federal and provincial taxes you’d be paying on your capital gains of 75K in 2020 would be $6380, quite a drop in taxes paid to our Canadian government.
Dividends get a bit more complicated for tax calculations and this is because it’s the only type of income of the four, which is post-tax income. This is because the money being paid to you as a dividend is profit from the company in which you invested. Since that company has made a profit, they have to pay taxes on it before paying it out to you as a shareholder and this is what makes it extremely tax efficient for you. To prevent the double taxing at absorbent amounts, the government provides dividend tax credits to offset your regular income tax bracket amounts. We’re going to skip the calculations to get these effectively new tax brackets for dividends are just tell you that they are pretty awesome! The first tax bracket actually works out to a negative tax rate of 0.03% which means you would actually get money back. How cool is that?! If we go back to our previous example of $75,000 and apply it as dividend income, your taxes owing would be a tiny $2125. That is 7 times less than what you would pay on employment income of the same value, a huge difference and money in your pocket. It is important to note that there are eligible (public companies) and ineligible (private companies) dividends and the rates are different. Eligible dividends are the ones which receive the best tax benefits, if they are not foreign. Yup you read that right! Foreign dividend income is taxed as regular income at a 100% inclusion rate and not applicable to any of the tax credits which make the above example so enticing.
Of course, it’s easy to play with the numbers and simply say that this kind of income has the best tax implications and therefore I’ll make the most money doing that. But there are many other factors, such as foreign and domestic investments and risk, which play huge factors in where your money is best invested. Tax is only one of them, but it is a very important one when it comes to the bottom line and should be included in every discussion and forecast of investment returns. A discussion best had with your financial advisor, but one which you’ll appreciate more as you understand the multitude of aspects to financial investing.