When you earn money from investments held in non-registered accounts, that income is taxable. Think of it as any other income you earn, like a salary. However, not all investment income is treated the same way by the Canada Revenue Agency (CRA). The three main types of investment income—interest, dividends, and capital gains—are each taxed differently.

Understanding these differences is key to managing your investments effectively. The way an investment's return is taxed can have a significant impact on how much of that return you actually get to keep.

Interest is the most straightforward type of investment income to understand, and it's also the most heavily taxed. You earn interest from things like Guaranteed Investment Certificates (GICs), bonds, or even just a high-interest savings account.

The full amount of interest you earn in a year is added to your income and taxed at your marginal tax rate. Your marginal rate is the tax rate you pay on your next dollar of income. So, if you earn $1,000 in interest, the entire $1,000 is added to your taxable income for the year.

Dividends are payments that some companies make to their shareholders, distributing a portion of their profits. How dividends are taxed depends on where the company is based.

Dividends from Canadian Companies

Dividends from eligible Canadian corporations receive special tax treatment. This is because the corporation has already paid tax on its profits. To avoid double taxation, the government gives you, the shareholder, a tax break.

This is done through a two-step process: the "gross-up" and the "dividend tax credit."

1. Gross-up: The dividend amount is first increased, or "grossed up," to an amount that theoretically represents the company's pre-tax profit. For 2024, the gross-up rate is 38%. So, a $100 dividend is reported as $138 on your tax return.
2. Dividend Tax Credit: You then get a federal tax credit to offset the higher taxable amount. This credit reduces the amount of tax you owe.

The result of this process is that the effective tax rate on Canadian dividends is significantly lower than on interest income.

Dividends from Foreign Companies

Dividends from companies outside of Canada do not get this preferential treatment. They are taxed just like interest income. The full amount is added to your income and taxed at your marginal rate. You may also be able to claim a foreign tax credit for any taxes withheld by the foreign country, which can help reduce your Canadian tax bill.

A capital gain is the profit you make when you sell an investment for more than you paid for it. For example, if you buy a stock for $10 and sell it for $15, you have a $5 capital gain.

Capital gains are the most tax-friendly type of investment income. In Canada, only 50% of your capital gain is taxable. This is known as the capital gains inclusion rate. The taxable portion is then added to your income and taxed at your marginal rate.

This favorable tax treatment encourages long-term investing and risk-taking in the economy.

At the end of the year, your financial institutions will send you tax slips summarizing your investment income. The most common ones are:

• T5 Slip: Reports interest and dividend income.
• T3 Slip: Reports income from mutual funds or trusts.
• T5008 Slip: Reports the details of security transactions, which you use to calculate your capital gains or losses.

You'll use the information on these slips to report your investment income on your annual tax return.

Knowing how different investment returns are taxed is a fundamental part of building a smart investment strategy in Canada.