Knowing how dividends are taxed in Canada can save you money

Dividends have tax advantages if you’re a Canadian resident.

You’ll still pay tax on dividends in the year you get them, but you’ll receive favourable tax treatment in Canada for dividends on Canadian companies because of the dividend tax credit.

Stocks with a history of raising their dividends are of great interest to investors looking to get the most from their investments. That’s because unlike bond-interest payments, which are taxed as regular income, Canadian dividends qualify for the dividend tax credit.

How dividends are taxed in Canada

Taxpayers who hold Canadian dividend-paying stocks get a tax break. Their dividends can be eligible for the dividend tax credit in Canada. This means that dividend income will be taxed at a lower rate than the same amount of interest income.

Investors in the highest tax bracket pay tax of 23% on dividends, compared to about 50% on interest income.

Investors in the highest tax bracket pay tax on capital gains at a rate of roughly 25%.

Savvy investors respect the tax advantages of dividends

Dividends don’t always get the respect they deserve, especially from beginning investors. A dividend stock’s yearly 2% or 3% or 5% yield may not seem like much to many investors, yet dividends are far more reliable than capital gains. A stock that pays a dividend of $1 this year will probably do the same next year. It may even rise to $1.05.

Savvy investors are paying more attention to dividend yields (a company’s total annual dividends paid per share divided by the current stock price), and the best dividend stocks respond by doing their best to maintain, or even increase, their payouts.

A couple of decades ago, you could assume that dividends would contribute up to a third of your long-term investment returns, even without the tax-cutting effects of the dividend tax credit.

In the early years of the past decade, dividend yields were generally too low to provide a third of investment returns. But many yields have moved up since then and interest rates remain low. That means today it’s realistic to assume they will again contribute as much as a third of your total return.

You should also keep these two key points in mind:

1. Dividends can grow. Stock prices rise and fall. That means capital losses can follow capital gains. Interest on a bond or GIC holds steady, at best. But strong dividend stocks like to ratchet their dividends upward—hold them steady in a bad year, and raise them in a good one. That can also give you a hedge against inflation.
2. Dividends are a sign of investment quality. Some good companies reinvest profits to spur growth instead of paying dividends. But fraudulent and failing companies hardly ever pay dividends. So if you only buy stocks that pay dividends, you’ll automatically stay out of almost all the market’s worst stocks.

For a true measure of stability, focus on companies that have maintained or raised their dividends during recessions and stock market downturns. These firms leave themselves enough room to handle periods of earnings volatility. By continually rewarding investors, and retaining enough cash to finance their businesses, they provide an attractive mix of safety, income and growth.

Are you pleased with how dividends are taxed in Canada? What is your experience with dividend investing? Have you taken advantage of the tax credits offered? Please share your story with us.