Interest is taxed more heavily than any other kind of investment income in Canada. So the same bond or GIC can leave you with very different results depending on what kind of bond it is and which account it sits in. This module covers how interest is taxed, two traps to avoid, and where your bonds belong.
In a non-registered (taxable) account, every dollar of interest is added to your income and taxed at your marginal tax rate, the rate on your next dollar of income. It is taxed every year, whether you spend it or reinvest it. GICs and bonds held directly are reported on a T5 slip; bond ETFs and bond mutual funds report on a T3.
Example. A $10,000 GIC pays 4%, or $400 a year. Your marginal tax rate is 40%. You pay $160 in tax and keep $240, so your after-tax yield is 2.4%.
There is no special treatment for interest the way there is for capital gains and Canadian dividends. That is why fixed income is usually the least tax-efficient thing to hold in a taxable account.
A capital gain is the profit when you sell something for more than you paid. Only half of a capital gain is added to your income, and it is taxed only when you sell.
Example. The same $400, earned as a capital gain at a 40% marginal rate: $400 × 50% × 40% = $80 of tax. You keep $320, instead of $240 as interest.
Canadian eligible dividends also get favourable treatment through the dividend tax credit; the Dividends & Income course covers that in Module 5, and Master Your Money compares every kind of income in How investment income is taxed.
Module 2 showed that a bond bought above face value (a premium bond) loses that premium by maturity. Before tax, the high coupon makes up for it. After tax in a taxable account, it does not: the coupon is fully taxed as interest, but the loss at maturity is a capital loss, which only counts at half value and can only be used against capital gains.
A discount bond works the other way: a small, fully taxed coupon, plus a gain at maturity that is taxed as a capital gain.
Example. Two five-year government bonds, each $10,000 of face value, held in a taxable account at a 40% marginal rate.
| Premium bond | Discount bond | |
|---|---|---|
| Price paid | 110 ($11,000) | 95 ($9,500) |
| Coupon | 5% ($500 a year) | 1.75% ($175 a year) |
| Interest over 5 years | $2,500 | $875 |
| At maturity | $1,000 capital loss | $500 capital gain |
| Profit before tax | $1,500 (about 2.7% a year) | $1,375 (about 2.9% a year) |
| Tax on interest (40%) | $1,000 | $350 |
| Tax on the gain or loss | −$200 (if you have gains to offset) | $100 |
| Profit after tax | $700 (about 1.3% a year) | $925 (about 1.9% a year) |
Before tax, the two bonds earn about the same. After tax, the discount bond keeps a third more profit on less money invested. The “a year” figures are simple averages of profit divided by the amount invested, to keep the comparison easy.
Some fixed-income investments pay nothing until maturity, but you still owe tax every year.
This is sometimes called phantom income: a tax bill with no cash to pay it. Inside an RRSP, RRIF, TFSA or FHSA it does not matter, which is where strip bonds and compound GICs usually belong.
Bond ETFs pass on mostly interest, reported on a T3 slip, sometimes with capital gains or return of capital. Distributions are taxable in the year paid, whether you take them as cash or reinvest them.
Choosing which account each investment goes in is called asset location. Because interest is taxed hardest, bonds and GICs gain the most from a shelter.
| Account | How interest is treated | Fit for bonds and GICs |
|---|---|---|
| RRSP / RRIF | Not taxed while inside; withdrawals taxed as income | Usually the first choice: withdrawals are taxed as income anyway, so nothing is lost |
| TFSA | Never taxed | Good, but TFSA room is often better used for the highest-growth investments |
| FHSA | Not taxed; tax-free when used for a qualifying first home | Good for a down payment needed within a few years |
| Non-registered | Fully taxed every year | Last choice; if you must, prefer discount bonds and GICs you plan to spend |
This is a starting point, not a rule. Someone whose only account is a TFSA should still hold the bonds they need there, and short-term savings for a near goal belong wherever they can be reached. Master Your Money covers the full picture in Asset location in Canada.
US investors: bonds usually go in tax-deferred accounts such as a traditional IRA or 401(k). Interest on US Treasuries is exempt from state and local income tax, and interest on many municipal bonds is exempt from federal tax. Canadians holding US-listed bond ETFs face extra withholding-tax questions, covered in US withholding tax.
Educational purposes only; not financial advice. Any bonds, funds, tickers, rates and figures are illustrative examples, not recommendations. Interest rates, deposit-insurance limits and tax rules change, so confirm current details with the issuer, CDIC and your tax authority. Worked examples are not forecasts. Written by Elizabeta Dimoska. Always do your own research and consult a licensed advisor.