Canadian capital gains tax: The cheapest tax you will ever pay

There are three forms of income in Canada: interest, dividends and capital gains. Each is taxed differently. Smart investors can use that to their advantage.

With stocks, you only pay capital gains tax when you sell or “realize” the increase in the value of the stock over and above what you paid for it. (Although mutual funds generally pass on their realized capital gains each year.)

Several years ago, the Canadian government cut the capital gains inclusion rate (the percentage of gains you need to “take into income”) from 75% to 50%.

For example, if an investor purchases stock for $1,000 and then sells that stock for $2,000, then they have a $1,000 capital gain. Investors pay Canadian capital gains tax on 50% of the capital gain amount. This means that if you earn $1,000 in capital gains, and you are in the highest tax bracket in, say, Ontario (46.41%), you will pay $232.05 in Canadian capital gains tax on the $1,000 in gains.

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The other forms of income are interest and dividends. Interest income is 100% taxable in Canada, while dividend income is eligible for a dividend tax credit in Canada. In the 46.41% tax bracket, you’ll pay $464.10 in taxes on $1,000 in interest income, and you will pay $230.60 on $1,000 in dividend income.

As Canadian capital gains tax is lower than the tax on interest and just above the tax on dividend income, capital gains is a very tax-advantaged form of income. However, since most investors have income of all three types, here are three strategies for structuring investment portfolios to minimize the tax burden.

1. It is usually best to hold any common shares outside of an RRSP (as dividend income and capital gains taxes are taxed lower than interest income), and interest-paying investments in an RRSP.

2. More speculative investments are best held outside of an RRSP. If investors hold them in an RRSP and they drop, investors not only lose money, but they can’t use the losses to offset any taxable gains from other investments.

3. Regarding mutual funds outside an RRSP, the main consideration is that mutual funds make annual capital gains distributions even if investors continue to hold the fund units. Investors then pay Canadian capital gains tax on half of any realized capital gains. So you are best to hold mutual funds in an RRSP and common stocks outside. You won’t realize capital gains on common stocks until you sell.

A properly structured investment portfolio can let you take advantage of the low tax rate on capital gains and dividend income while sheltering your higher-taxed interest income in your RRSP. If you hold dividends or capital gains in an RRSP, you gain the tax shelter of the RRSP, but when you withdraw the funds from your RRSP they are taxed at the same rate as interest income. This means you would lose out on the lower tax rates offered.