Taxes on Interest vs Dividends vs Capital Gains

A friend asked about how dividend taxation works and the difference in tax rates between the different types of investment revenue - interest vs dividends vs capital gains. He tried unsuccessfully to figure out the answer browsing through the Canada Revenue Agency's comprehensive but daunting website. Since he, being a smart guy, did not succeed, I figure this is worth a post for someone else's benefit.

I must acknowledge the excellent free Taxtips website, already linked under the Resources sidebar of this blog, for providing the calculators and information that produced the following results, though of course, if I've made any errors of interpretation that's not their fault.

The tax calculation of Canadian dividends goes through a grossing up process of the actual dividends we receive by cheque. Currently, this means adding 45% on top of the actual dividend, and the new higher amount is included in our taxable income. Yikes, you may say, that will raise my taxes! But through a clever tax credit calculation on the amount, the CRA gives it back and we all end up better off. Better even than interest or capital gains. (I'm referring to the most common type of dividends, those paid by companies listed on stock exchanges such as the TSX. See this Taxtips page for the nitty gritty of what is in this category termed "eligible" dividends.)

Use the Taxtips calculator to do your own numbers for your own province. I used Ontario for me and my friend. For almost every tax bracket, dividends have the lowest marginal tax rate, better even than capital gains, which may surprise some. The dividends tax advantage against capital gains diminishes progressively as you go up in tax bracket, being about 1% in the $72k-118k brackets for 2006. In the very top bracket, over $118k, the tax rate is higher on dividends. However, both dividends and capital gains have a significantly lesser tax rate - half or less - than interest or ordinary income (like salary) at all taxable income levels. (See this Taxtips chart, which shows both 2006 and 2007 brackets and marginal rates for Ontario.) That's why we are constantly told to put our bonds, GICs, CSBs and the like into our tax-sheltered RRSP.

Hmm, those banks stocks and utilities look better and better.