Canadian Tax Season is Approaching: How Should Investors Prepare?

Most Canadians take advantage of tax sheltering within a Registered Retirement Savings Plan (RRSP) or through the tax-free benefits of a Tax-Free Savings Account (TFSA). However, outside of registered accounts, tax efficiency plays a key role in building wealth.

■ Not all income is taxed the same way

Investment income varies in form, with the most common types being interest, dividends, and capital gains.

Like wages, interest income typically comes from investments such as Guaranteed Investment Certificates (GICs) or savings deposit accounts and is taxed at an individual's highest marginal tax rate. This makes interest the least tax-efficient form of investment income.

Dividends paid by stocks receive more favorable tax treatment because this income benefits from the federal dividend tax credit, making it more tax-efficient than interest income.

Capital gains occur when investments are sold at a price higher than their book value. Like dividend income, capital gains benefit from preferential tax treatment, as only 50% of the gain is subject to taxation. Both dividends and capital gains are commonly associated with equity investments.

Before delving into the taxation of investment income, it is crucial to grasp the structure of Canadian tax brackets. Canada operates under a progressive income tax system, where individuals earning less are taxed at lower rates than those with higher incomes.

Additionally, it is important to note that Canada implements a dual-layer income tax system, consisting of federal and provincial taxes. The tax bracket you fall into depends on the total income and the place of residence.

A prevalent misunderstanding is the belief that being in a higher tax bracket subjects your entire income to a higher tax rate. However, in a progressive tax system, only the income that falls into higher brackets is taxed at those increased rates.

There are five federal income tax brackets in place. The exhibit 1 above displays the federal tax rates applicable for the year 2024.

Tax-loss harvesting, often called tax-loss selling, is a strategy available to investors holding non-registered investments such as stocks, bonds, mutual funds, and ETFs that have decreased in value below their purchase price. By selling these investments, investors can realize a capital loss, which can be applied to offset capital gains incurred during the same tax year. Additionally, these capital losses can be carried back to any of the three preceding tax years or carried forward indefinitely to offset future capital gains.

For example, investors can sell loss-making bank stocks and buy Canadian bank stock ETFs. This way, investors will receive tax benefits from the capital losses incurred from selling the bank stocks, but can still maintain their investment in the financial sector because ETFs or mutual funds are considered "significantly different" from the original positions. Although this solution does not provide investors with an investment exactly the same as the previous position, it allows investors to participate in the potential rebound of the industry.

However, it is important to note that if a capital loss is triggered after selling, investors cannot deduct that loss if an identical security is bought within 30 days of the transaction's settlement date. Additionally, "affiliates," such as a spouse or common-law partner, or a corporation controlled by the same individual or their spouse or common-law partner, are also prohibited from making the purchase, as per the Canada Revenue Agency.

Considering that the tax on interest income is higher than that on dividends, and with the Bank of Canada cutting interest rates, investors might consider shifting their investments of interest-bearing assets into high-dividend stocks.

It's important to construct a well-diversified portfolio that aligns with your investment objectives. Incorporating the right balance of cash, fixed income, and equities is essential for building wealth and fostering accelerated growth over time. Each component should be chosen with care to maximize returns and manage tax liabilities effectively.

A Tax-Free Savings Account (TFSA) can support various savings objectives. Its primary advantage is that any capital gains, interest income, and dividends accrued within the TFSA are not subject to taxes, either during the accumulation phase or upon withdrawal.

Within a TFSA, investors can hold a wide array of investment vehicles such as stocks, bonds, mutual funds, and Guaranteed Investment Certificates (GICs), provided they qualify under the TFSA regulations. For 2024, the maximum contribution limit is set at $7,000.

Another beneficial investment vehicle is the Registered Retirement Savings Plan (RRSP), which not only provides tax advantages but also facilitates systematic savings for retirement and other financial goals. By contributing to the RRSP account, investors can lower their taxable income for the year by the contribution amount if there's still sufficient contribution room. This effectively defer taxes until a future date.

Taxes are only due upon withdrawal from an RRSP, at which point the funds are taxed as ordinary income. Many opt to withdraw from their RRSP during retirement, anticipating a lower marginal tax rate at that time. For 2024, Canadian residents can contribute up to 18% of earned income from the previous year, with a maximum of $31,560, in addition to any unused RRSP contribution room from the end of the prior year.

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