Dividends: Not as tax-friendly as you may think

If your investments include RRSPs, TFSAs and taxable accounts, asset location is an important consideration. The returns of various asset classes—such as bonds, Canadian stocks, and foreign stocks—are treated differently under tax law. So by selecting the most tax-advantaged assets for your non-registered accounts, you should be able to keep more of the returns for yourself.

As most investors know, eligible dividends from Canadian companies are taxed at a much lower rate than interest and foreign dividends. In fact, for Canadians who make less than $40,000 or so, the tax rate on dividends is actually negative, which means you can use them to lower the amount of tax you pay on other income. That’s why the conventional wisdom is that Canadian dividend-paying stocks are the most tax-efficient asset class.

That is true in many cases, but the dividend tax advantage is often overstated. For taxable investors who have above-average incomes, it may not make sense to focus on dividends at all.

Dividends v. capital gains

Recall that stock returns come in two flavours: dividends and price appreciation, or capital gains. While dividend investors unleash the hounds on me whenever I make this argument, these are two sides of the same coin: a company’s earnings can either be reinvested (which causes the value of the stock to rise) or paid to shareholders as cash dividends (which causes the stock price to fall), or some combination of both. Ignoring taxes, a stock that appreciates by 5% and pays no dividend delivers the same return as one that appreciates just 2% but also pays a 3% yield.

Of course, you can’t ignore taxes if you’re investing in a non-registered account, and for Canadians with relatively low incomes, these two types of returns are taxed very differently. For an Ontario taxpayer with an income of $42,000 in 2012, the marginal rate on eligible Canadian dividends is just 3.8%, while the rate on capital gains is more than 12%. (My source for all tax rates in this post is TaxTips.ca). Obviously, someone in this situation would prefer Canadian equities that paid a high yield at the expense of lower price appreciation, and therefore might reasonably choose a dividend-focused ETF in a taxable account. Something like the iShares Dow Jones Canada Select Dividend Index Fund (XDV) would be an excellent choice.

For higher-income Canadians, however, the difference in tax rates between eligible dividends and capital gains is much less significant. In Ontario, for example, with an income of $81,000, eligible dividends are taxed at 19.9%, while the rate on capital gains is actually a bit lower at 19.7%. And at the highest tax bracket, capital gains are taxed at a much lower rate: for income over $132,000, the rate is approximately 23% for capital gains and 30% for dividends.

The differences are similar for high-income investors in British Columbia, Manitoba, and Quebec. They are smaller in Alberta, Saskatchewan and the Atlantic provinces.

Should you really prefer dividends?

Equity investors who are building index portfolios in taxable accounts should think carefully about whether they really should focus on Canadian dividends. If you’re in a high tax bracket, it might make sense to look at Canadian equities that pay less in dividends and deliver most of their returns in the form of price appreciation.

As you can see from the above chart, the iShares Dow Jones Canada Select Growth Index Fund (XCG) has seen much greater price appreciation than the than the iShares Dow Jones Canada Select Dividend Index Fund (XDV). However, because growth stocks, by definition, don’t pay generous dividends, the yield on XCG is only about 0.7%. Meanwhile, XDV pays about 3.8% in dividends annually.

As it turns out, over the last five years, the two ETFs delivered virtually identical total returns: 1.85% versus 1.87% annualized. However, investors in a high tax bracket would have kept more of XCG’s returns for themselves. Because capital gains are only taxable in the year they are realized (that is, when you sell at a profit), an investor who held XCG in for the whole five years would have only paid tax on that very small dividend.

The information in this post should in no way be considered tax advice for individuals. Always consult an accountant or qualified advisor before making any investment that has tax consequences.