Why dividends matter

Readers of My Own Advisor know I’m a big fan of companies that reward shareholders with dividends.

And why not love dividends?  Although I use a few indexed products in my investment portfolio, getting paid on a consistent basis from Canadian and U.S. stocks is a beautiful thing.  Digging deeper, is there an advantage to be gained from the dividend investing approach over other investment strategies?  Is there only a psychological benefit?  Why do dividends matter?  Let’s take a look at some reasoning why dividends matter.

Benefit #1 – Canadian Dividend Tax Credit

You should know that dividends paid from many Canadian companies are eligible for a tax credit when you hold these Canadian companies in a non-registered account.  In a RRSP, every dollar of dividend paid will be taxed as income when withdrawn and for your TFSA, the dividend tax credit is lost.  The tax credit is an advantage over other forms of income you might make, including employment income or income from other investments, like bonds or GICs, since the taxation on these types of income is higher.  Here’s a link to a post on Million Dollar Journey that discusses the dividend tax credit in some detail.  You can find much more information about the dividend tax credit on taxtips.ca.

Benefit #2 – Consistent Payments

Dividend-paying stocks probably don’t get enough credit because providing 3% or 4% or 5% income is not nearly as sexy (or financially rewarding) as seeing your non-dividend paying stocks rise 10% or more in a given year.  However, companies that pay dividends can’t fake those payments to shareholders, at least for very long.  Besides, can you predict when a stock is going to get hot?  I can’t.  Recall that dividends paid is real money paid from real company profits.  Buying and holding an established company that has paid dividends for decades is a good sign (at least from a historical perspective) that this company had enough cash flow to reward shareholders and stay in business.  Companies that don’t pay dividends tend to use their money for other means, grow their business; make acquisitions or buy-back shares, driving the stock price higher over time.  These are not poor management decisions by any means and these decisions could turn out to be more rewarding for investors over dividends, with capital gains abound.  When it comes to the capital gains versus dividend income debate, there really isn’t a debate to be had, since every dollar you earn in capital gains from a stock is worth just as much as your dividend dollar paid.  Dividends from established companies however are paid consistently, and dividend payments might even rise over time, so this level of predictability can provide some financial security especially when you’re invested in a diverse portfolio stocks.

Benefit #3 – Staying Psyched about your Financial Plan

There is definitely something magical about seeing money earned from your investments come into your account, and then seeing that money buy more investments, every month, every quarter and every year.  When your money starts making money and that money earns more money, you’ll well into the magical world of compounding.  This really isn’t magic as you know, and dividend paying stocks aren’t the only investment vehicles that can participate in this wealth-building recipe.  Yet participating in dividend reinvestment plans for your investments, including your dividend-paying stocks, is a great way to stay psychologically motivated about your financial plan especially when markets get rough.

One of the best financial books I’ve read, The Investor’s Manifesto by William Bernstein, talked about the attributes of a successful investor:

  • They must possess an interest in the process,
  • They need more than a bit of math horsepower, far beyond simple arithmetic ,
  • They need a firm grasp of financial history, and
  • They need “the emotional discipline to execute their planned strategy faithfully, come hell, high water, or the apparent end of capitalism as we know it.

This last point, one that Bernstein stresses is all for naught if investors don’t posses this fourth attribute, is likely the single biggest benefit provided to investors who follow a dividend-investment strategy.  The emotional high of getting paid, regularly, from many companies, instead of waiting for capital gains to be had, helps dividend investors avoid making too many emotional mistakes.  Receiving consistent dividends and increasing dividends over time, can foster a positive psychological image of your money working for you so you don’t have to someday.  Capital gains from non-dividend payers actually have the same effect but they aren’t as visible because most investors are not patient enough to see other strategies through long enough.  The power of positive reinforcement that dividend payments can provide can help you stick to a long-term financial plan.

Dividends matter for many reasons to investors.  Do they matter to you?

14 Responses to "Why dividends matter"

  1. I think your benefit #3 is the best one. Most people can’t fill both their RRSP and TFSA, so the dividend tax credit will become less important over time for people with low to medium income. For people with incomes over $90,000 in retirement, capital gains taxes are actually lower than dividend taxes.

    Consistent payments are great, but we can’t invest in the past. We can’t know which dividend payers will stop paying. It seems that all companies eventually fade away, even the ones that pay dividends consistently for decades. Whether we plan to live on divdends or capital gains, some companies will disappoint us. So, stay well diversified.

    If using dividend stocks helps you stay psyched about your financial plan and stay invested when the market hits bottom, then this is a good approach for you. Few things can derail a financial plan like panic.

    Reply
    1. Thanks for the comments Michael. I think point #3 is the biggest for me, since to your point, I am investing in CDN stocks in my TFSA, so I lose the dividend tax credit.

      I’m not sure I’ll ever have >$90k income in retirement, that’s very good income though.

      Your point about consistent payments is good, but all returns are in the past, including capital gains.
      This probably makes your case for indexing even more valid? 🙂

      Point #3 is becoming the biggest for me, sticking with a plan I believe in.

      Reply
      1. I’m not sure what you mean by losing your dividend tax credit because it is in a TFSA.. Unless you are making very little income and in certain situations where you pay an effective negative tax rate on dividends (rare) it is always better to pay zero tax (TFSA) than a little tax (dividend tax credit)…

        So what is it that you are losing by holding Canadian dividend companies in your TFSA?

        Reply
        1. Hey Matt,

          Thanks for your question.

          Here is the definition of the dividend tax credit:
          The amount a Canadian resident applies against their tax owing on the grossed up portion of dividends received from Canadian corporations.

          As you know, a tax credit reduces one’s tax liability. You can reduce your tax liability if you own eligible dividends from a Canadian company. However, those dividends must be in a non-registered account. For dividends paid by Canadian companies that are held in a TFSA or RRSP account, you lose the ability to claim the dividend tax credit when you file your taxes. This is because, a) the TFSA is a tax-free account (you’re already getting the tax-break on dividends) and b) the RRSP is a tax-deferred account (you will pay back the dividends you got deferred on when you withdraw monies from the account).

          Here is more reading:
          http://www.cra-arc.gc.ca/gncy/bdgt/2013/qa04-eng.html

          I hope that makes sense?

          To answer your question, yes, it is always better to pay less tax which is why it makes great sense to hold Canadian dividend-paying, income-bearing assets in your TFSA. I’m with you there 🙂

          Mark

          Reply

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