Silent Wealth Crusher #2 - Income Taxes

Don’t get me wrong, I'm ok with paying taxes. But I'm not ok with paying more taxes than I should. The issue is that unless you took a tax 101 class in university or are an accountant, it’s not easy to find the right information online to understand how taxes impact your wealth. 

How are income taxes calculated

Before we dive into how taxes affect your investments, let’s just look at how income taxes get calculated. In Canada, we operate with ‘tax brackets’. Every province will have slightly different brackets, but for simplicity, I’m using 2023 Ontario’s tax brackets (and bundling federal and provincial taxes together). 

FYI, they change every year! But don't worry, your tax software (or accountant) will do all these calculations for you. 

To understand how much taxes you owe, add up all your ‘gross’ sources of income. 

Gross = amount you get paid before any taxes are applied (i.e. if  your salary is 75K, this is usually a gross annual number)

Net = amount you get paid  after all taxes are applied (i.e. what you keep) 

Then go through the calculation from the table above to understand how much you will owe in income taxes.  

If you are paid via payroll, this calculation is mostly done for you, and what hits your bank account when you get your paycheque, is the net amount. You company takes care of paying your taxes to the government automatically. If you're self-employed, you'll have to budget for paying your taxes at the end of the year.

Canadians file a tax return each year to calculate how much tax they owe vs how much they have already paid. In some instances you might have underpaid your taxes (i.e. you had other sources of income than your paycheque, and need to pay taxes on those), or overpaid (i.e. you were able to apply deductions to your total income, reducing the amount of taxes you owe). 

Deductions are things like retirement savings, or childcare expenses. The government allows you to effectively reduce your salary (only for the income tax calculation, don't worry) by those amounts to reduce the income tax you need to pay. For example, you made $100K this year, and contributed $20K to your RRSP. For the sake of calculating income taxes, the calculation will be based on a salary of $80k (100k-20k). If  through your payroll, you paid taxes on $100k salary, then at the end of the year, you will get refunded for taxes you paid on the $20k that went to your RRSP account** (i.e. you get a tax refund). 

**There is a limit every year to how much you can put in your RRSP account. That limit is available in your CRA online account. 

What does this mean for my investments

So now that we understand the basics, we can delve into WHY taxes can be a wealth crusher if we don’t think about  tax implications when we make our savings and investments decisions. 

When we save and invest, we usually generate some level of revenue (gains) in the form of interest (high yield savings account or GICs  for example), dividends (from stocks) or capital gains (when you sell a stock for a higher price than what you bought it for). But unlike payroll revenue, you don’t pay taxes on this revenue before the money hits your bank account: it’s the gross account that hits your bank account. For the income tax calculation, revenue from all these sources is added to your income, and you end up having to pay the taxes you owe on this revenue. 

Worth noting that:

• If some of this incremental revenue is in the form of capital gains, it will only get taxed at 50% of your marginal tax bracket.  

• Canada has several options for tax free accounts. They are called ‘registered’ accounts: TFSA, FHSA, RESP, RRSP, etc. Revenue you  make from investments within those accounts is NOT added to your  total income, and thus NOT taxed.

A few examples might make things clearer: 

Let’s say you make $150k a year from your bank job. This year, you also made $20k in interest from a GIC you held in a non-registered investment account. At the end of the year, the government will assess your taxes on $170K income (150+20). If  you refer back to the table above, this incremental 20K will get taxed at around 48%. On that specific portion of your income (the $20K interest), you will owe ~$9.6k in taxes. 

Your neighbour also makes $150k a year from their tech job. This year, they also made $20k but in the form of capital gains (they sold stock for a $20K profit) held in a non-registered investment account. At the end of the year, the government will assess their taxes on $170K income (150+20) but only charge them half of the taxes on the $20K  capital gains. If  you refer back to the table above, this $20K will get taxed at around 48%/2. On that 20K capital gain, they will owe ~$4.8k in taxes. 

Shelly also makes $150k a year from her medical job. This year, she also made $20k in interest from a GIC held in her TFSA, a registered investment account. At the end of the year, the government will only assess their taxes on $150K since the interest was made in a registered account. On that 20K interest income, she will owe $0 in taxes. 

As you can see, even with the same base salary, and same additional income from their investments, these 3 will generate a very different tax owed at the end of the year.

Bottom line. For most investors, especially if you're just starting, I would keep two things in mind.  

1. In general, it makes sense to try and  maximize your registered accounts first before investing in cash or margin accounts. In addition, I would try and max out  my RRSP contributions, before anything else, since not only the will my money grow tax free but the contributions are income tax deductible.

2. Keep high interest generating investments (GICs, High Rate Savings, etc) for registered accounts. Since interest income is taxed at 100% of your marginal rate, and capital gains (on stocks for example) are only taxed at 50% of your marginal rate, if I'm going to hold both types of investments, I will keep the interest generating investments for my tax sheltered accounts.  

Follow me on instagram @wealthyfeminist for more tips and tricks (i.e. what qualifies as tax deductions for example) and happy investing!