Tax treatment of Canadian dividend paying stocks

Tax treatment of Canadian dividend paying stocks

This is an updated post, to support answers to more reader questions. Read on and enjoy!

I got this email in my inbox recently:

“You write about Dividend Reinvestment Plans (DRIPs) often. I wonder if you would discuss the beneficial tax treatment of dividends and DRIPs. I’m not sure everyone understands the tax benefits or implications!”

Thanks for your comments and suggestions.

Let’s get to my thoughts and answers!

Tax treatment of Canadian dividend paying stocks – How I Invest

You might already know by now, I’m a hybrid investor.

That means to me, the following:

Approach #1 – I own many Canadian dividend paying stocks for rising cashlow/income.

You can always keep tabs on what I own and why here.

Approach #2 – I own a few low-cost ETFs to diversify my porfolio beyond Canadian borders and those individual stocks – mostly for growth. 

At the time of this post, I’m down to just under 30 Canadian stocks in my Canadian dividend income portfolio. 

I figure that’s enough.

I’m likely to pare that list in the coming years to be more concentrated. 

Just like the holdings of many popular Canadian ETFs, I own a mixture of the following (and likely will for the foreseeable future for growing dividend income):

• 5+ Canadian banks
• A few life insurance companies
• A few pipeline companies
• A couple of telecommunications companies
• A few utility companies
• A few industrial companies
• A few energy companies
• A handful of Canadian Real Estate Investment Trusts (REITs).

You can find out how I built this dividend income portfolio here – and how you can too!

How I built my dividend portfolio

Tax treatment of Canadian dividend paying stocks

Many DIY investors aspire to have a few income streams to fund early retirement with. 

I am no exception!

Taxable investing is helpful (beyond contributions to your TFSA and RRSP every year), because there is no limit in how much you can invest inside a taxable/non-registered account. 

While I always prioritize maxing out my TFSA (tax-free investing) first, then my RRSP (tax-deferred investing), I also invest in a taxable account and have do so for many years. 

I have done this because I continue to aspire to have multiple income streams and sources to fund semi-retirement with.

In a few years, we hope to have the following personal assets to draw down in no particular order beyond government benefits:

1. x1 – my defined benefit pension plan from work (about 21 years in at the time of this post).
2. x1 – my wife’s defined contribution pension plan from work (also about 20 years contributed).
3. x1 – my Locked-In Retirement Account (LIRA).
4. x2 – RRSPs.
5. x2 – TFSAs.
6. x1 – taxable account.
7. x1 – corporation; soon to be corporate investment account.

___________

9 accounts. 

Why dividends?

While there are a number of ways to generate passive income (you could have rental properties and more?!), my wife and I decided long ago that dividends from the stock market will work for us.

While dividends are just part of an investors’ total return formula, they are an important part of total return.

Reference: Honestmath.com

I like dividends for a few reasons:

1. I continue to believe there are simply too many unknowns about the future. Having ample income generated from our portfolio will give us financial options/retirement draw down options. 
2. If we are able to keep our capital intact we don’t need to worry as much about when to sell shares or ETF units when markets don’t cooperate.
3. “Living off dividends” is my form of forced savings – there is motivation to reach our $1 million portfolio goal and spend the income from it – leave the capital intact for a few years. I intend to spend the dividends or distributions from our portfolio only in the early years of semi-retirement. 
4. I don’t necessarily believe in the 4% rule. It’s impossible to predict next year let alone 30 more investing years. Seeing dividends roll into my account helps me psychologically to stick to my investing plan.
5. Dividends are tangible money I can spend if and when I choose without worrying about stock market prices or gyrations.

In addition to my above list, high-quality, established companies that pay dividends are fairly predictable. Not only do these companies pay a consistent dividend – they often deliver growing dividends as well.

Therefore, it is my hope that ever growing dividends (and capital gains) can meet my income needs AND work together to help fight inflation. As consumer prices rise, as the cost of living rises, the companies that deliver our products and services will rise in price along with them.

Finally, I like owning Canadian dividend paying stocks because they are are tax-efficient. 

With my RRSP growing more with U.S. assets, I tend to keep Canadian dividend paying stocks in my TFSA and inside my non-registered account for favourable taxation.

In a taxable account Canadian dividend paying stocks are eligible for a dividend tax credit from our government. This means taxation on dividends are favourable, it is a lower form of tax; lower than employment income and interest income in many income brackets.

Let’s explore that below!

Tax treatment of Canadian dividend paying stocks – TaxTips and more

I’ve known for some time now that I get a tax-break per se by investing in Canadian dividend paying stocks owned outside registered accounts like my Registered Retirement Savings Plan (RRSP) and my Tax Free Savings Account (TFSA). You should know this too!

Here’s the thing – companies pay taxes on their earnings, just like you and me.

For dividend paying companies those dividends come to us from after-tax profits.

Investors who hold Canadian dividend paying stocks get to offset the taxes already paid by the company in non-registered accounts. (CRA basically subsidizes dividend investors for the tax the corporation already paid on dividends.)

This is performed by a “gross-up” of eligible and non-eligible dividends.

1. For eligible dividends from Canadian corporations only – they are “grossed up” by 38%. (For dividends to officially be recognized as eligible dividends, they have to be designated as eligible by the company paying the dividend.)
2. The gross-up rate for non-eligible dividends, as of 2019, is 15%.

Note:  The gross-up and dividend tax credit are applicable to individuals, not corporations.

The punchline is this: Canadian-sourced dividends are profits that you receive from your share of the ownership in a corporation. The gross-up is meant to determine the taxable dividend amount for an individual to include as reportable income. 

You can find more information on this from TaxTips.ca

Here is my simplified example for eligible dividends; those from pretty much all of my Canadian stocks.

• Let’s say I earned $1,000 in eligible dividends. The CRA gross-up is 38%. The grossed-up dividend income is $1,380.
• Let’s say my marginal tax rate in Ontario is 40%. That’s about $552 in taxes payable before the Dividend Tax Credit (DTC) is applied.
• Now for the DTC – there is a federal and a provincial tax credit available to me. The DTC provides a credit for about the same amount of tax the company has already paid. I love using TaxTips.ca as my source for this (no affiliation).
• The federal DTC is 15.02% of the grossed-up dividend. In this case that would be about $207.
• Provinces also kick in their own DTC and I live in Ontario. The DTC in Ontario is 10% of the grossed-up dividend.
• The combined federal and provincial DTC for me is 25.02%.
• Applying this percentage to the grossed-up dividend total of $1,380 and I get a total dividend tax credit of about $345.

That’s a nice credit but it’s really just tax integration.

The lower my marginal tax rate is however, the lower the taxes payable before the DTC is applied AND the better the tax treatment after the DTC is applied.

Effectively, if you had no other income other than income from Canadian dividend paying stocks in a taxable account, about less than $50,000 in income actually, you wouldn’t pay any income taxes.

Here’s the proof in table and link below!

(Note: The Ontario Tax Rates Table is reproduced with the permission of TaxTips.ca.)

Source: https://www.taxtips.ca/taxrates/on.htm

So, for investors holding Canadian dividend paying stocks inside taxable accounts – you are eligible for the Canadian dividend tax credit. 

So, you can see from the link assuming you have NO other income besides taxable dividend income, in Ontario, you would pay very little income tax (up to a particular point). This is mostly due to the dividend tax credit outlined above. So, essentially, any retiree that relied on just dividend income (and no other taxable income sources in Ontario or many other provinces and territories for that matter) could effectively live off $50,000 or so per year, per person in tax-free income!

If $50,000 to live from tax-free isn’t enough, well, you may have a partner or spouse too. So, between you both, that could be $100,000 per year in combined tax-free income (depending on the province that you live in of course)!

What about foreign dividends?

Foreign dividends are not eligible for the Dividend Tax Credit in Canada in any situation.

Therefore, investors receiving dividends in Canada from a foreign corporation will pay a higher tax rate on them without Dividend Tax Credit relief. Something to think about when it comes to asset location – what stocks to own where!

(Given that foreign corporations are generally not subject to Canadian corporate tax, this means dividends you receive from foreign corporations are not subject to the gross-up, nor are you eligible for the dividend tax credit. Foreign dividends you receive, such as those paid by U.S. or European companies, are fully taxable to you. This tax treatment results in higher taxes payable on a foreign dividend than on a Canadian-source dividend. In addition, there may be withholding tax on the foreign dividends. In a non-registered account at least, you can claim a federal foreign tax credit to a maximum of 15% on your Canadian income tax return.)

How realistic is the tax-free tax treatment of Canadian dividend paying stocks?

Not really 🙂

I mean, sure, it’s quite possible but most early retirees or retirees that I know do not have just/only taxable dividend income from Canadian stocks to file their tax returns with. 

More realistically, they have workplace pensions, or RRSP/RRIF income, then some CPP and OAS as well. Maybe all of these income sources. The point is, knowing how and why various income sources like Canadian dividends are taxed can work in your tax-efficient favour. 

Taxtips.ca has some amazing free calculators here.

Because there are endless ways to structure your portfolio, I encourage you to consider hiring a tax accountant if your tax needs are very complex.

Implications with Dividend Reinvestment Plans (DRIPs)?

There are a few…

I love DRIPs because they help keep my investing activities on autopilot. 

Money comes in, gets reinvested, rinse-and-repeat.

You can read about a long list of pros and cons with DRIPs here.

However, if you’re investing in Canadian dividend paying stocks for income like I am, sometimes in a taxable account outside your TFSA or RRSP, you’ll need to keep track of your Adjusted Cost Base (ACB).

What the heck is that?

Adjusted Cost Base (ACB) is a calculation used to determine the cost of an investment for tax purposes. It’s really only relevant to taxable accounts because you already know the TFSA is a tax-free account, funded by after-tax dollars. You also already know the RRSP is a tax-deferred account.

When you sell an asset, like a Canadian dividend paying stock, you may have a capital gain or a capital loss.  Running DRIPs for long periods of time in a taxable account can complicate your ACB since additional, commission-free, reinvested dividends every month or quarter essentially add new stock purchases to your portfolio. These purchases need to be tracked and included in your ACB.

Thankfully there are a number of spreadsheets and even free online tools you can use for ACB – this is one of my favourites (no affiliation) at adjustedcostbase.ca.

Tax treatment of Canadian dividend paying stocks summary

I currently DRIP most of my Canadian companies. Most of the reinvesting work takes place inside my TFSA and RRSP although some DRIPs do occur in a taxable account.

This means I can take advantage of the Canadian Dividend Tax Credit but I also must keep track of my Adjusted Cost Base in this taxable account.

Over time, I will continue to hold a handful of Canadian dividend paying stocks in a taxable account, taxed on dividend income today but also deferring capital gains for as long as I can.

I will also earn a good portion of my Canadian dividends tax-free (thanks TFSA) as long as I continue to max out contributions to the TFSA before semi-retirement. 

Thanks to readers for these comments and questions. Keep them coming!

Mark

Key source: www.TaxTips.ca.