Tax treatment of Canadian dividend paying stocks
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 issues or implications.
Thanks for your comments and questions. Let’s get to my answers.
Regarding my dividend investing strategy
You might already know by now, I’m a hybrid investor. I own many Canadian dividend paying stocks for cash flow/income and I own a few ETFs for long-term growth. Most of the index investing I do is inside my RRSP account with U.S.-listed ETFs.
Back to the stocks…my portfolio consists of close to 40 Canadian companies at the time of this post.
I figure that’s enough.
Just like the holdings of many popular Canadian ETFs, I own a mixture of the following (and likely will for the foreseeable future for passive income):
- 5-7 Canadian banks
- 3 life insurance companies
- A few pipeline companies
- 3-4 telecommunications companies
- 4-5 utility companies
- 1-2 industrial companies
- 3-5 energy companies
- 5-7 Real Estate Investment Trusts (REITs).
Tax issues with Canadian dividend paying stocks?
There are some things to be mindful of.
I’ve known for some time now that I get a tax-break 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 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.
A simplified example for eligible dividends:
- 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.
- 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.
That’s very nice.
So, for investors holding Canadian dividend paying stocks inside taxable accounts – you are eligible for the Canadian dividend tax credit. U.S. stocks are not and you can read more about U.S. stock tax treatment here. This makes the following “standard advice” for direct stock ownership as follows:
- Dividends from U.S. stocks are taxed in Canada like interest income.
- Capital gains on U.S. stocks are taxed favourably like Canadian stocks. Consider holding U.S. stocks that pay little to no dividends in a taxable account.
- Consider holding U.S. stocks that pay dividends inside your RRSP.
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.
Regarding my dividend investing strategy
I currently DRIP most of my Canadian companies. Most of the reinvesting work takes place inside my TFSA although some DRIPs do occur in a taxable account. This means I can take advantage of the 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, deferring capital gains for as long as I can. I will also earn a good portion of my Canadian dividends tax-free (thanks TFSA).
Thanks to readers for these comments and questions. Keep them coming.