Topic: Dividend Stocks

Take full advantage of the Canadian Dividend Tax Credit

December 6, 2017|by Scott Clayton

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The Canadian dividend tax credit can significantly boost your investment returns

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

Canadian dividend stocks are an attractive way to increase profit with the least amount of risk. This is the case with blue chip stocks that have dividend records going back many years or decades, and include the potential for tax-advantaged capital gains as well as the dividend tax credit.

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Savvy investors know about the tax advantages of the Canadian dividend tax credit

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 raise it to $1.05.

Smart investors now pay 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.

How to use the dividend tax credit to cut your effective tax rate

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 around 29% on dividends, compared to 50% on interest income—investors in the higher tax bracket pay tax on capital gains at a rate of 25%.)

The Canadian dividend tax credit in action

If you earn $1,000 in dividend income and are in the top 50% tax bracket, you will pay about $290 in taxes.

That’s a bit more than capital gains, which offer tax-advantaged income as well. On that same $1,000 in income, you will only pay $250 in capital gains taxes.

It’s a lot better than the roughly $500 in income taxes you’ll pay on the same $1,000 amount of interest income.

Note that the Canadian dividend tax credit is actually split between two tax credits. One is a provincial dividend tax credit and the other is a federal dividend tax credit. The provincial tax credit varies depending on where you live in Canada.

So apart from the Canadian dividend tax credit giving you a major tax-deferral opportunity, dividends can supply a big part of your overall long-term portfolio gains.

High dividend-paying stocks can be a big part of long-term investment gains

The best dividend stocks can be a valuable component of any investment portfolio. These stocks provide a consistent dividend yield year after year. That’s key to your long-term investment success, because, as we said earlier, dividends overall can contribute as much as a third of your total return.

Above all, for a true measure of stability, focus on stocks that have maintained or raised their dividends during economic or stock-market downturns. That’s because 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 also provide an attractive mix of safety, income and growth.

Bonus tip: Dividend payments don’t affect your capital gains tax—unless they’re reinvested in additional shares. Dividend payments in cash do not change the shares’ adjusted cost base. You pay tax on the dividends as received each year at the rate fordividends, not capital gains.

However, if the dividend payments are reinvested in additional shares of stock, then the total cost and total number of shares change after each new dividend reinvestment, and you must recalculate your new adjusted cost base. Note that you must still pay taxes on reinvested dividends each year as received.

Consistent dividend payments are a sign of investment quality. What are some reasons you have in the past declined to invest in a dividend-paying company?

Is the Canadian tax credit enough to get you to buy dividend-paying Canadian stocks? Or would you buy them anyway, and the tax credit is just a bonus?