Not All Investment Investment Returns Are Created Equal

When Canadians think about investment returns, they often focus on performance: the number on the statement that says, "Your portfolio gained 8% this year." But what really matters is what you get to keep after taxes. And not all investment returns are taxed the same way.

Most Canadians begin their investment journey in tax-sheltered accounts like RRSPs and TFSAs. In these accounts, tax treatment of income is either deferred (RRSPs) or eliminated (TFSAs). That means few people pay attention to how interest, dividends, or capital gains are actually taxed. But once you max out your registered accounts and start investing in taxable accounts, the rules change. And the differences in tax treatment become much more important—especially if you're planning to live off your portfolio one day.

The Taxation of Investment Returns in Canada

Investment returns are typically categorized into three main types: interest income, dividends, and capital gains. However, there’s a fourth, less widely understood form—return of capital—that’s eventually taxed as a capital gain but deserves its own distinct place in the conversation.

Each of these income types is taxed differently, and the overall tax efficiency of your investment strategy can vary significantly depending on how your returns are composed.

Here's a simplified example where a 5% return can produce very different after-tax outcomes:

Understanding Each Return Type

1. Interest Income

Interest from bonds, GICs, savings accounts, and most fixed-income investments is fully taxable at your marginal tax rate. If you're in the top bracket in Ontario, that means giving up more than half your interest earnings to CRA.

2. Dividends

Dividends from publicly traded Canadian companies receive preferential tax treatment through the dividend tax credit. While more efficient than interest, the gross-up and credit system can result in a higher nominal income being reported, which may impact income-tested benefits like Old Age Security.

3. Capital Gains

Only 50% of capital gains are taxable in Canada. This makes them more efficient than interest or dividends. Plus, capital gains are only taxed when realized (i.e., when you sell), allowing for some tax deferral.

4. Return of Capital (ROC)

Return of capital is a unique and highly tax-efficient form of investment income. It's not taxed when received but instead reduces your adjusted cost base (ACB) of the investment. Tax is only paid later, when you sell the investment and realize a capital gain. This allows you to defer tax for years and potentially pay it at a lower rate in retirement.

Private real estate funds, infrastructure partnerships, and certain income trusts often distribute a portion of their returns as ROC. While it may sound less appealing than "real" income, ROC can be a powerful tool for tax planning and enhancing after-tax returns.

Why This Matters More Over Time

If you’re still working, your focus might be on growing your wealth in RRSPs and TFSAs. In those accounts, all return types are treated equally (tax-deferred or tax-free). But once you hit your contribution limits and move to a non-registered (taxable) account, the tax treatment of income starts to bite.

It matters even more when you retire. As you shift from growing wealth to generating passive income, the kind of income you earn can significantly impact how much you keep. If you're relying on portfolio income to pay your bills, the difference between earning 2.3% vs. 5.0% after tax can make or break your retirement plan.

A Real-World Scenario

Let’s say you have $1 million invested and are in the highest tax-bracket. You could:

Put it in a mix of GICs and Bonds yielding 5%, earning $50,000 in interest. After-tax cash-flow = ~$23,000.
Invest in Canadian dividend stocks yielding 5%. After-tax cash-flow = ~$30,000.
Invest in private real estate funds distributing 5% as ROC: no tax due this year, and you keep the full $50,000.

That’s a significant difference in cash flow and can have major implications once you begin relying on your investments for income. While you’ll eventually owe $13,500 in capital gains tax when you sell the investment, that may not happen for 5, 10, or even 20 years. By then, inflation will have eroded the real value of the tax owed. Tax deferral is a powerful—yet often underappreciated—advantage in wealth planning.

Planning Tips

Asset Location: Hold interest-generating assets in RRSPs or TFSAs where possible.
Be Strategic with Capital Gains: Defer gains until low-income years (e.g., retirement).
Use ROC Wisely: Consider income-oriented private investments that return capital tax-deferred.
Work with an Advisor: A well-constructed portfolio considers not just what you earn, but what you keep.

Final Thoughts

Tax efficiency isn't just a footnote—it's a central part of smart investing. Most Canadians ignore this until they start investing outside registered accounts or try to live off their portfolio. But the sooner you understand how different income types are taxed, the better your long-term outcomes will be.

ROC, in particular, is underappreciated. While it may feel like you’re "getting your own money back," the tax deferral and compounding advantages are real. Especially when used in conjunction with a diversified portfolio of stocks, bonds, and private assets.

As you grow your wealth, don’t just ask, "What is the return?" Ask, "What is the after-tax return?" That’s the number that counts.

You Earned an 8% Return—But How Much Did You Keep?