Topic: Dividend Stocks

The dividend tax credit provides a special bonus for Canadian investors

February 10, 2017|by Pat McKeough

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The dividend tax credit offered to Canadians can greatly increase your investment returns.

This article was originally posted on October 5, 2016.

Canadian taxpayers who hold Canadian dividend stocks get a special bonus. Their dividends can be eligible for the dividend tax credit in Canada. This dividend tax credit—which is available on dividends paid on Canadian stocks held outside of an RRSP, RRIF or TFSA—will 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. At the same time, investors in the highest tax bracket pay tax on capital gains at a rate of about 25%.

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For example:

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.

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.

A couple of decades ago, you could assume that dividends would supply up to about one-third of the stock market’s total return. Dividend yields are generally lower today than they were a few years ago, but it’s still safe to assume that dividends will continue to supply perhaps a third of the market’s total return over the next few decades.

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.

When you add in the security of stocks that have dividend records going back many years or decades—and include the potential for tax-advantaged capital gains on top of dividend income—Canadian dividend stocks are an attractive way to increase profit with less risk.

Dividends are a sign of investment quality

At TSI Network, we feel that a long-term record of a stock paying dividends gives investors a measure of safety. Dividends, after all, are much more stable than earnings projections. More important, dividends are impossible to fake—either the company has the cash to pay them or it doesn’t.

Some good companies reinvest their profits 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.

Dividend stocks rarely get the respect they deserve, especially from beginning investors. That’s because a yearly 2% or 3% or 5% dividend barely seems worth mentioning alongside possible yearly capital gains of 10%, 20% or 30% or more.

But dividends are far more reliable than capital gains. A stock that pays a $1 dividend this year will probably do the same next year. (It may even raise the rate to $1.02 or more).

The best part is that dividends can grow. Stock prices rise and fall, so capital losses can follow capital gains, at least temporarily. Interest on a bond or GIC holds steady, at best. But good companies like to ratchet their dividends upward—hold them steady in bad years, raise them in good ones. That also gives you a hedge against inflation.

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 at the same time retaining enough cash to finance their businesses, they provide an attractive mix of safety, income and growth.

And as mentioned, Canadian investors have the added advantage of the Canadian dividend tax credit to make the most out of their dividend income producing investments.

Have you taken advantage of the dividend tax credits in Canada? How helpful has it been to your returns? Share your experience with in the comments.