If you are considering buying a guaranteed investment certificate (“GIC”) in Canada, you need to know how it will be taxed in order to know what your “after-tax” return on the investment will be. Interest earned on a GIC is taxed as income by both the provincial and federal governments, unless the GIC is held in a registered account such as a Tax Free Savings Account (“TFSA”) or Registered Retirement Savings Plan (“RRSP”).
Buying a GIC that offers a 2% annual return on a $100,000.00 investment, for example, doesn’t mean that you will actually end up with a $2,000.00 return in your pocket at the end of the year. This is because the interest earned on GICs is taxed at your marginal tax rate. So in this example, if you are in a 50% marginal tax bracket, you will only end up with $1,000.00 in your pocket at the end of the year, because you are required to pay $1,000.00 of that $2,000.00 in earned interest as income tax. Your actual after-tax return on your investment ends up being only 1%.
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For term GICs (i.e. GICs with a term of longer than 1 year), you will also have to pay tax each year on the interest that you have earned but not yet received. This is so even if you are not entitled to receive the interest until the end of the contract. The CRA treats the interest as income once it is earned, not after it is actually received. So, if you are considering buying a 5 year GIC, then you will have to pay income tax on the interest earned at each anniversary date of the contract.
There are some exceptions to this. If you hold the GIC in a TFSA then the interest is earned tax-free.If you hold the GIC in an RRSP, the interest is not taxed while in the RRSP, but is taxed when you withdraw your money form the RRSP. There is also an exception for what are called “market or equity-linked” GICs. These types of GICs offer a return based on the performance of an underlying stock market index. These types of GICs are not taxed until the end of your contract because your rate of return is unknown until maturity. If the market does not perform well,for example, you may see no return on your investment.
Aside from the tax consequences of buying a GIC, you should also consider the terms of the contract, and whether you will be able to access your money before the end date of the contract if needed. Some GICs are “non-redeemable” meaning your money is locked in for the term of the contract and you cannot access it. Other GICs might be redeemable before expiry of the contract but require you to pay a penalty to cash out early.
If you have a question about interest income, types of GICs, dividend income, or capital gains, it is always best to consult an experienced tax lawyer,accountant, or financial planner.