Starting to invest? Here's how to save on your taxes

If you're new to investing, one of the first questions you're likely to ask is, "Do I need to pay taxes on investment income?"

The short answer is, yes. However, how much you'll pay depends on various factors, such as where you live, your marginal tax rate (i.e., the tax rate that applies to your highest tax bracket) and what types of investments you're holding. There are also ways to reduce taxes on income from investments if you plan accordingly.

Before you start trying to figure out how much investment income is taxable, it’s important to understand Canadian tax brackets. Canada has a graduated income tax system. People with a lower income pay a lower tax rate than people with a higher income. 

It's also worth noting that there are two layers of income tax in Canada: federal and provincial. Your total income and where you reside will determine your tax bracket.

One common misconception is that if you fall into a higher tax bracket, you'll pay a flat rate of taxes for your entire income. That's not the case since a graduated income tax system means you're taxed at a higher tax rate on additional dollars earned in the next tax bracket. 

There are currently five federal income tax brackets.

The table below shows the federal tax rates that apply for 2024. Again, keep in mind that in addition to federal tax, you must also pay provincial tax, which varies by province.

Taxes on investment income in Canada will vary depending on what products you hold. The key is knowing what type of distributions you're receiving from your investments as this will determine the type of taxes you pay.

When purchasing products, such as bonds, guaranteed investment certificates (GICs), or treasury bills, you earn interest income. This income is fully taxable and gets added to your overall income. The amount of your tax obligation will depend on your marginal tax rate. 

Dividends are paid by corporations to their shareholders.  Dividends can also be earned through investing in mutual funds.  While dividend income is taxable, tax credits are available for both eligible and non-eligible dividends that can reduce your tax burden. Generally speaking, eligible dividends come from companies taxed at the general corporate tax rates, such as publicly traded companies. Non-eligible dividends typically come from companies taxed at lower corporate rates. 

Any income earned from a foreign source, which includes interest and dividends, is fully taxable at your marginal tax rate as regular income. However, if you paid foreign taxes on this income, you may be able to claim a foreign tax credit.

Generally, if you purchased investment products, such as stocks, in a non-registered account and they had gone up in value when you sold them, you will have realized a capital gain, and 50% or one-half of that gain (known as the inclusion rate) is subject to tax. For example, let's say stocks you purchased increased in value by $5,000 when you sold them. In this case, you’d have to pay taxes on $2,500, which gets added to your taxable income.

Here are some ways you can look to reduce your overall tax burden.

Your Tax-Free Savings Account (TFSA) can be used for a variety of different savings goals. The appeal of a TFSA is that all capital gains, interest income and dividends grow tax free in your TFSA and can be withdrawn tax free.

You can purchase many different investment products within your TFSA, which includes stocks, bonds, mutual funds, GICs, and more, as long as the products are qualified investments for TFSA purposes.

Your Registered Retirement Savings Plan (RRSP) is another investment option that offers you a tax benefit, but also helps you save systematically and prepare for retirement and other financial needs.  Depending on the contribution room available, you can reduce your taxable income in the year by the amount you contribute to your RRSP.  This is one way to defer taxes payable to the future.

Additionally, you only get taxed when you withdraw from your RRSP and this would be taxed as regular income. Many people are likely to withdraw from their RRSP when they're in their retirement years, when they expect their marginal tax rate will be lower.

Another way to manage your tax rate is contributing to your partner’s spousal RRSP to enable income splitting. This happens when the higher-income partner contributes to the spousal RRSP of the lower-income partner to help reduce the overall tax paid by the family.  The higher-income partner can then claim the tax deduction. If  you think you might be able to take advantage of income splitting, consult with a tax expert, as each couple's situation will vary.

If you plan to become a homeowner, consider contributing to a First Home Savings Account (FHSA).  

Unlike an RRSP, contributions you make within the first 60 days of a calendar year will not be counted toward the previous tax year or deducted against your previous year’s income, as FHSA contributions are made into and deducted on a calendar-year basis.

Like RRSP contributions, you are not required to claim the FHSA deduction in the tax year a contribution is made. The amount can be carried forward indefinitely and deducted in a later tax year, which may be beneficial if you expect to be in a higher marginal tax bracket in a future year.