MoneySense answers your dividend questions

Over the past couple of weeks Norm has been taking your questions regarding dividend stocks. Here are his responses:

I’d like to thank everyone for all the interesting questions!

Before getting to the answers, I’ll start with a few disclaimers.

Several questions were related to tax matters. In such cases I give general replies which should not be construed as tax advice. You should consult your tax advisor for specific answers to questions about your particular circumstances. Frankly, I don’t know enough about your situation to really know how best to advise you.

The same thing goes for investment-related advice. Again I provide general suggestions which should not be construed as investment advice. An investment advisor should be consulted to advise you on your particular portfolio. Again, I don’t know enough about your particular situation to be able to provide proper guidance.

So, I answer questions in a general manner. As a result, my suggestions may not be suitable for an individual’s particular situation.

What happens to dividends on stocks held within a RRSP mutual fund? (i.e. any equity fund) Are they used to fund additional stock shares or paid to the fund management? —Joel

Norm responds: The equity mutual fund holds stocks and its return is composed of capital gains (changes in the price of stocks) plus dividends plus interest on any excess cash (etc) minus the fund’s fee. So, in some cases the fee charged by the fund may equal or exceed the dividends paid by the stocks it holds. That’s why it’s important to keep an eye on the fees and, all else being equal, opt for lower fee funds. For low fee funds, most of the dividends would be reinvested and used to buy more stock.

Great article! I’ve always wanted to have some sort of dividend investment. But how to I get on this wagon? I’m 31 years old, married, have a mortgage, and we have our first baby on the way. Im an investment newbie and I have no idea where to start this process. Pretty much the only investments I have going for me is my tiny $50 contribution to an RRSP every month. How do I go about starting a dividend portfolio? Do i call my bank? They will probably take half my dividend cheque just on fees?! Once I get a portfolio established, can I add or buy more dividends easily so that I can hopefully get a bigger cheque in the mail every month?
— Lo$t

Norm responds: Congratulations on starting early. It can be hard to grow a portfolio while growing your family.

Starting with a very small portfolio is tricky. Many funds require a $500+ initial investment and commissions on stock purchases can eat up a small portfolio. For those with less than $5,000, simply opting for GICs or high interest savings accounts can be a good way to go. It might be boring but at least it provides a stash of cash for emergencies.

At the $5,000 level, I like simple low-fee balanced funds which are a great option for building up a nest egg. Once an even more sizeable portfolio is established, one can then opt for more complicated strategies. For those with $5,000+, the Mawer Canadian Balanced RSP fund is a good option. It charges a 1.01% annual fee which comes to about $50 a year on a $5,000 investment. (Investors also get some top notch active management to run their money.) It might even be a good idea to just stop there and stick with low-fee balanced funds for a long time. But investors might start to branch out when they hit about $50,000.

The more adventurous, with time on their hands, may want to explore the world of Dividend ReInvestment Plans (DRIPs) and Share Purchase Plans (SPPs). (See my site http://www.stingyinvestor.com/SI/DRPs.shtml)

In January 2010 I started using a discount brokerage firm, investing in ETFs, and educating myself about self-directed investing (never thought it would be so interesting and fun!). What RRSP eligible dividend producing ETFs (monthly or quarterly) would you recommend? I’m a single female in my 40s with modest amounts to invest, a medium risk tolerance, and plans to retire in 18 years. —Newbie

Norm responds: While I can’t make specific recommendations for your portfolio, see my reply to Lo$t if you have a more modest account.

For larger accounts, the ETFs mentioned in the article should be considered. On the Canadian side, the iShares Canadian Dividend Index Fund (Symbol: XDV, 0.50% annual fee) and the Claymore S&P/TSX Canadian Dividend ETF (Symbol: CDZ, 0.64% annual fee) are good options. On the U.S. side, the Vanguard Dividend Appreciation ETF (Symbol: VIG, 0.24% annual fee) and the Vanguard High Dividend Yield ETF (Symbol: VYM, 0.20% annual fee) should be considered.

Regrettably, most Canadian discount brokerages don’t currently offer U.S. dollar RSP accounts which means that currency exchange related costs might bite a bit. But U.S. dollar accounts seem to be becoming more popular and may become widespread in a couple of years.

I have a couple of questions. Is there an easy way to determine the after tax real return to an investor from a dividend paying stock. I realize it is easy to calculate the % return to the stock price, however when the actual dividend is adjusted upward by 45 % for tax reporting and then the dividend tax credit is applied and maybe you are a senior with OAS concerns, are dividends a good tax efficient income source. The second question I have is why the actual dividend is increased by 45% for tax reporting purpose? —Fred

Norm responds: The tax situation can be complicated. You have to deal with both capital gains and dividends. If you hold for more than a year (which is often a good idea) then the dividends will be taxed in more than one tax year. For real returns you also have to factor in inflation. (Crack out a spreadsheet and your tax software.) So, in most cases, it’s not easy to determine after-tax real returns. It’s even harder to predict them!

The OAS clawback starts to hit at about $66,000 in income. But talk the matter over with your accountant.

A quote from KMPG should answer your last question. “The taxation of dividends received by individuals from Canadian corporations is designed to reflect that the corporation paying the dividend has already paid tax on its profits. The amount included in the individual’s income is “grossed up” to approximate the total amount of pre-tax income that the corporation is presumed to have earned. The individual then receives a credit to offset the tax the corporation is presumed to have paid.”

My question is about dividends in mutual funds (ETF or index funds) that are outside an RRSP. Do dividends earned from the stocks held in the fund flow back to the unit holder as pure dividend income? —Erica

Norm responds: Yes, that’s the general idea but the dividend income may be reduced by the fund’s annual fee. (The fee is often removed first from less tax-advantaged income, such as interest, before eating into dividend income.)

I’ve been reading a lot lately about dividends and the importance of dividend growth. My question is how is dividend growth calculated? For example, over five years is it just the average of the dividend growth rates for each year individually, or do you take the dividend at year 1 and compare it to the dividend in year 5? Is there a standard way of calculating dividend growth? —Steve

Norm responds: Well, there isn’t really a standard method. Some sources use the current dividend compared to that from 5 years ago and then annualise the growth. Others like to use trailing 12-month figures. So, 1-year growth might be based on the dividends paid over the last 12 months versus those from the prior 12 months. You’ll have to check the method used with each data provider.

Regarding U.S. dividend stocks: Capstead Mortgage corp (CMO – NY exchange) pays about 18% dividend now, it is supposed to have only government guaranteed mortgages. Are there any inherent problems to this in paying dividends. If we own it in RRSP, does the U.S. government still withhold taxes, before paying dividends? —Devender

Norm responds: Sorry, I don’t follow CMO and can’t comment on its merits. Very quickly, I note that it is a leveraged U.S. REIT and the 18% yield should give one pause for concern. It seems doubtful that it’s a risk-free investment.

As to U.S. withholding taxes, they shouldn’t apply to RRSPs based on the Canadian/US tax treaty which can be found at http://www.fin.gc.ca/treaties-conventions/in_force–eng.asp (particularly article XXI). But give your broker a quick call to confirm this for any particular security.

With stocks seeming to be relatively cheap, and dividend yields relatively high, do you think it would be wise to take out a heloc and invest some of this money (maybe 10-15% of the value of our mortgage-free home) in high-quality Canadian dividend-yielding stocks, that more than cover the heloc rate (not even counting the dividend tax credit, and potential capital gains!)? —Fifi

Norm responds: It might work out just great but I admit to being debt phobic. (Perhaps irrationally so!) So, I’ll offer up the following quote by Warren Buffett on the topic of leverage, “I’ve seen more people fail because of liquor and leverage—leverage being borrowed money. You really don’t need leverage in this world much. If you’re smart, you’re going to make a lot of money without borrowing.”

I see in most provinces one can make up to 50k in dividends without paying much if any in taxes. Does this apply to all Canadian preferred shares like CPD (Claymore S&P/TSX Preferred ETF)? —vanwash85

Norm responds: Generally speaking, preferred shares issued by Canadian corporations that pay eligible dividends are tax advantaged. But you’ll want to check on a case by case basis. You can find the distribution information for CPD over at http://www.claymoreinvestments.ca/etf/fund/cpd/distributions.

I was surprised your dividend portfolio did not include bank stocks. I’ve held bank stocks in my RRSP portfolio for several years. They are on a drip with the dividend interest buying more shares. They’ve been an excellent source of investing in my opinion. BMO has a current yield of 4.6%, Bank of Nova Scotia is 3.8% and RBC is at 3.3%; all within your yield parameters. I’m going to buy many of the stocks you recommended in your mini-portfolio but I’ll definitely be adding more bank stocks.
—Balvenie

Norm responds: Bank stocks have been good dividend stocks but they didn’t make the list because they didn’t grow their dividends during the downturn. In the article, our list only contains stocks that have recently grown their dividends. But, with a little luck, the banks will start boosting their dividends again shortly.

Aside from dividends, I tend to like the big Canadian banks much more when they’re trading below book value. Now that they’re trading at a substantial premium to book value I’m less bullish on them.

I want to know how U.S. dividend stocks are taxed if outside or inside a RRSP or TFSA? —Sonlan

Norm responds: Generally speaking U.S. dividends are treated as income outside RRSPs/TSFAs. U.S. dividends outside RRSPs are also subject to U.S. withholding tax. TFSA’s get hit with the withholding tax but, unlike regular accounts, they don’t benefit from the dividend tax credit. So, TFSA’s may not be a good spot for U.S. dividend stocks.

I am interested in the food industry stocks. I have not been able to locate Sobeys stock value for today. You recommended Saputo – today’s share price is $28.67 and the stock gives 0.15 cents/share Loblaws price today is $38.42 and the stock gives 0.50 cents/share. Can you tell me what the advantage of buying Saputo is over Loblaws?
—Leona

Norm responds: Loblaws hasn’t been growing its dividend in recent years which is why it didn’t make the list. FYI, according to globeinvestor, SAP is currently yielding 2.0% versus Loblaws at 2.2%. So, the dividend yield is about the same but SAP has a much higher return on equity and net profit margin than L. SAP has also typically trades at a premium to Loblaws. But that’s not to say that I hate Loblaws only that the dividend growth investor would favour SAP at the moment.

I have investments outside my RRSP and within my RRSP. In a low interest rate environment am I better off having dividends stocks within my RRSP / GICs outside my RRSP or vice versa? If the interest rates go up does the advice change? I am thinking dividend stocks are better outside the RRSP for tax reasons but when interest rates are very low as today, it seems total tax paid is lower with GICs outside my RRSP. —Soopster

Norm responds: Unfortunately the details matter when it comes to taxes (high income vs. low income, etc.). Very generally speaking, most people like to shelter interest generating investments inside RRSPs.

But you also have to consider how long the low interest rate environment is likely to last. Is it worth doing a big switch (at the cost of lots of commissions / triggering capital gains tax) for an advantage that might be fleeting? I don’t know but I suspect that the cost might well outweigh the potential advantages. Nonetheless, it’s an interesting point to consider.

I was really amazed by reading your article. I started investing four years ago, and I always wanted to have dividend stocks. Could you please advise me where I can buy those dividend stocks? Right now I have mutual funds with CIBC and I’m interested in getting extra income from dividends. —Lesya

Norm responds: You can buy dividend stocks through a stockbroker. CIBC has both a full service and discount broker that you could use. (Full service comes with advice for a price and discount is cheap but you’re on your own.)

Take it slow it when you’re just starting out. It’s best to do a fair amount of reading before taking the plunge and it’s wise to begin in a small way so that any mistakes won’t hurt that much. But don’t be intimidated either!

I need to know whether I should buy the TD e-Series mutual funds in order to boost my returns, specifically a friend, who still believes in the US Recovery, recommended I buy the TD US Index which has a low MER 0.50% and start setting up automatic monthly contributions and/or should I but the Vanguard Dividend Appreciation ETF (VIG) which costs only 0.24% annually or even the Vanguard High Dividend Yield ETF (VYM) cost here ).20% annually. —Nick

Keep in mind that I can’t make specific recommendations for your portfolio. But I might suggest you consider a diversified portfolio that includes more than just U.S. stocks. Also, the Vanguard Total Stock Market Index ETF (VTI, 0.07% annual fee) might be a good replacement for the more expensive TD US Index fund.