Earned vs Passive Income and Why it Matters

Hello All,

A common concept that I find myself explaining, when I talk to people about their taxes, relates to earned vs passive income.

This might sound a bit yawn inducing, but (like marginal tax rates), the type of income you earn determines how it’s taxed, how much you can contribute to your RRSP, and even what benefits you qualify for.

Earned Income: Money from Your Effort

This is the money you actively work for:

• Your salary or wages

• Freelance or consulting income

• Profits from your business

• Rental income (if reported personally—it’s passive when earned in a corporation)

Passive Income: Money from Your Assets

This is money that comes from things you own:

• Interest from savings or GICs

• Dividends from stocks

• Capital gains (profit from selling investments)

How This Affects You

1. Your Tax Bill

Earned Income: Taxed at your regular tax rate (the more you make, the higher the rate)

Passive Income:

• Interest and foreign dividends = taxed at your full rate

• Canadian dividends = taxed at a lower rate due to a tax credit

• Capital gains = only 50% of the gain is taxable at your marginal tax rate

2. Your Retirement Savings (RRSP)

This is crucial to understand and one of the key differences : Only earned income creates RRSP contribution room.

• Earn $50,000 → You can contribute $9,000 to your RRSP (18%)

• Earn $50,000 in capital gains → No RRSP room created

3. Government Benefits

• Canada Workers Benefit: Only those who earn employment income are eligible to receive this

• Old Age Security (OAS): Both income types count toward the clawback threshold i.e. once you earn over a certain amount, your OAS has to be repaid to CRA.

• Canada Child Benefit (CCB): Both types of income affect how much you receive

Simple Strategies That Make a Difference

For Everyone:

1.       Use Your TFSA First: Investment income in a Tax-Free Savings Account is tax-free and doesn't affect government benefits

2.      Choose Canadian Dividends: If investing outside registered (RRSP/TFSA/FHSA) accounts, Canadian dividend-paying stocks get better tax treatment

3.      Time Your Investment Sales: You only pay tax on investment profits when you sell (realized gains). Planning this in advance can help you reduce your tax bill.

For Parents:

Child care expenses can only be deducted against earned income (not investment income)

Higher earned income can mean lower Canada Child Benefits (but also higher RRSP room)

For Homeowners:

If you rent out part of your home, that rental income creates RRSP room

And of course keep track of rental expenses as they reduce your taxable rental income

Common Mistakes to Avoid

1.       Ignoring the TFSA: Many people max out RRSPs first, but TFSAs might be better for investment income. The allocation between the two should be part of a balanced investment strategy.

2.      Not Tracking Rental Expenses: Every legitimate expense reduces your taxable rental income

3.      Panic Selling Investments: Remember, you only pay tax when you sell and make a profit

4.      Forgetting About Dividend Tax Credits: Canadian dividends are much more tax-efficient than interest

Final Takeaways

Earned income builds your RRSP room and qualifies for work-related benefits
Passive income can be more tax-efficient, especially Canadian dividends and capital gains
Rental income is considered earned income
TFSAs are a great vehicle for investing
Timing matters when selling investments due to the way progressive tax rates work.

Understanding the difference between earned and passive income can help you make smarter financial decisions, both now and in the future. And while tax planning can get complex, knowing the basics can lead to a direct improvement in your bottom line.

As always, I'd love to hear your thoughts.

Wishing everyone a lovely weekend!

Ronika