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Ask An Advisor: Interest, capital gains, dividends – What’s the difference?

How to Know When it’s Time to Incorporate Your BusinessQ: What is the difference between interest, capital gains, and dividends? Is there a difference in the way they are taxed?

A: For the purposes of this post, I’ll assume the profits on interest, capital gains, and dividends are not in registered accounts like TFSAs, RRSPs, LIRAs, or RRIFs, but rather in non-registered taxable investments.

Interest

Interest payments are created when an investor loans someone or an organization (like a bank) money. Interest payments are commonly found in GICs, bonds, mortgages, and bank accounts.

Every dollar of interest paid to an investor is taxable in the year the investor receives it. In other words, if someone is paid $10,000 in interest on a loan in 2014, that $10,000 is taxable income. If this investor earned a salary of $100,000 in 2014, they would be taxed as though they made $110,000.

Capital Gains

On the other hand, only half of capital gains are taxable. Capital gains are created when investors profit from the sale of a security or property (not including their primary residence). These gains are only taxable in the year in which they are sold. They can also be used to offset an investment that was sold at a loss during the same year.

If an investor purchased a Canadian ETF in 2011 for $100,000 and sold it in 2014 for $110,000, it would be considered a $10,000 capital gain for the 2014 tax year. However, only $5,000 would be taxed.

If that investor earned a salary of $100,000 in 2014, they would be taxed as though they made $105,000 (half of the $10,000 gain).

Dividends

Now on to “eligible” Canadian dividends. Here’s where things can get a bit complicated. Eligible dividends are paid by a public company to its owners or shareholders as a method of sharing the company’s profits.

Unfortunately, calculating the taxation of eligible dividends is not as cut and dry as it is for capital gains or interest. Like interest, dividends are taxed in the year in which they are received. However, the amount earned through a dividend is “grossed-up” by 145% in what’s called the enhanced dividend tax credit. After that, a tax credit of eleven eights of this “gross-up” is applied to the investor’s income.

Let’s flesh this out a bit more. If an individual earns $100,000 in 2014 and was paid $10,000 in dividends that same year, the $10,000 dividend would be “grossed up” to $14,500 (145% of $10,000 dividends received). A tax credit of $8,861.11 (11/18 of the grossed up $14,500) is then applied to end up with a taxable amount of $5,638.88 (the remainder of the $14,500).

This $5,638.88 is then added to the $100,000 salary earned in 2014, as taxable income. After all these calculations, the investor is ultimately taxed on $105,638.88.

Lastly, one of the quirks in the calculation of “eligible” dividends is that investors who earn less may not pay any tax on dividends. However, higher earners usually pay less tax than on interest income, but more than on capital gains. This chart will help illustrate the point.

If you’re still feeling shaky on these concepts, feel free to send me an email. I’ll be happy to clarify.

The information above is from sources believed to be reliable; however, we cannot represent that it is accurate or complete and it should not be considered personal tax advice. We are not tax advisors and we recommend that clients seek independent advice from a professional advisor on tax-related matters.

Ask An Advisor is a regular feature based on commonly asked questions I’ve received from clients. If you have a question, shoot me an email. I will write back and post your question in this series for the benefit of other readers. If you don’t want your question posted online, or wish to remain anonymous, let me know.