Dividend downer

When is $100 in income treated like $144? When you’re a Canadian dividend investor.

Dividends from Canadian companies can offer big breaks for income-oriented investors, and they’re getting a lot of hype these days in the press, but they’re not always as tax-friendly as people believe. “Dividend stocks are still good,” says Steve Cummings, president of Cambridge Financial Services in Halifax, “but are they always the best from a tax perspective? The answer is no.” The problem is that dividends can artificially inflate your income, potentially triggering a clawback of Old Age Security (OAS) payments.

Confused? You’re not alone. It’s far from intuitive, but on your tax return, you have to “gross-up” your dividends by 44% and declare that amount as income. Then you can claim a tax credit (18% in 2010) on the higher amount. So if you collect $100 in Canadian dividends, you must report it as if you received $144 as income.

Normally, that doesn’t matter, you still pay less in tax than you would on employment income, for instance. But the gross-up can push you over the OAS clawback line, which can create complications for seniors. For instance, the feds claw back Old Age Security benefits when a retiree’s income is higher than $66,733. A senior who earns $55,000 from pensions and another $10,000 in dividends may think she comes in under the limit, but be pushed over by the gross-up.

Investors near these thresholds might be better off holding dividend-paying stocks inside their RRSP, according to Mike Macdonald of Weigh House Investor Services in Toronto. Another strategy is to invest for capital gains: while $100 in dividends must be reported as $144, a capital gain of the same amount increases your taxable income by just $50.

Dividends and capital gains are treated differently by the taxman. This example shows how a dividend gross-up can mean an OAS clawback*.