Dividend Investing Part 2: Are Dividends Tax Efficient?

In the last post, I explained how dividends are irrelevant on their own. However, they may be relevant depending on whether the psychology is helpful or harmful. Regardless, psychology and the narrative are part of the appeal of dividend investing and why some are also emotionally invested in the strategy. While a dividend may be economically irrelevant in an academic sense, the tax implications are relevant in the real world.

Some dividend investing promoters point to specific cases where dividends are tax-efficient. However, those may not extrapolate well to other common situations. While tax efficiency is a secondary consideration for most investors, it is important. This post examines the tax efficiency of dividends in registered and taxable personal investment accounts.

Dividend Taxation in Tax Shelters

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Registered Accounts (RRSP, TFSA, FHSA, RESP)

Many people think that dividends do not matter in a tax-sheltered registered account. However, the tax-free status inside these accounts may only apply to Canadian taxes. There are still foreign withholding taxes (FWT). FWT applies to foreign dividends but not to capital gains or interest. So, choosing to have more of your return as a dividend increases the tax drag on the investment return for foreign stocks. That also applies to ETFs and mutual funds, that hold those stocks. Even if you do not see it, the tax is collected prior to the dividend being paid to you.

Whether FWT applies also depends on the account type. RRSPs are usually exempt from FWT if Canada has a tax treaty with the country and the stock or fund is listed on their exchange. For example, SPY is a US-listed ETF that emulates the S&P500 and has no US FWT in an RRSP. In contrast, VFV.TO is a Canadian-listed ETF that holds the same US companies, but FWT would apply to the dividends (even in an RRSP).

Foreign dividends received in a TFSA, FHSA, or RESP are all subject to FWT. Because there is no Canadian tax in these accounts, you cannot recover the FWT paid when you file your taxes, like you would be able to in a taxable non-registered account.

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How Big of a Deal is FWT?

For most broadly diversified investors, FWT matters, but it is not huge. It is 15% of US dividends, and averages about 9% for other foreign dividends (depending on the country). Importantly for ETFs and mutual funds, the FWT is applied to the dividend before management fees of the fund.

For a diversified broad market investor, the gross (pre-fee) dividend yield is typically in the 2-3%/yr range, depending on the market. That is higher than the yield you will see reported for the ETF or mutual fund. The reported yield is net of fees, and FWT in the case of Canadian-listed ETFs. The FWT component translates into a roughly 0.3%/yr tax drag on performance. Annoying, but not devastating to broad market investors.

However, if you are pursuing dividends, the yield that the FWT applies to is higher. For example, the 2024 yield for the S&P 500 was 1.47%, translating into 0.22% of FWT. In contrast, the 2024 yield for the S&P 500 Dividend Aristocrats Index was 2.53% translating into 0.38% of FWT. Dividend-focused ETFs often have even higher dividend yields to be taxed, and also tend to have higher fees as well.

In a TFSA, RESP, or FHSA, the FWT plus higher fee would require the dividend ETF to outperform by 0.42%/yr total return compared to the broad S&P 500 ETF to break even. We will discuss whether that is a reasonable expectation in a future post (Spoiler: Probably not, and NOBL has trailed SPY by >3%/yr since inception in 2013 – not even counting the FWT).

Eligible Dividend vs Capital Gain Tax Rate

Dividend investors focused on Canadian companies do not have to worry about foreign withholding taxes. In fact, the dividend tax credit is often cited as a reason to seek out eligible dividends while investing in a tax-exposed non-registered personal account. When you are paid an eligible dividend from a publicly listed Canadian company (directly or through a fund), you get a corresponding enhanced dividend tax credit.

The dividend tax credit reduces your personal income tax bill. It is not an unfair tax break or incentive to invest in Canada. It is part of tax integration. Tax integration is a pillar of our tax system that attempts to tax income earned individually versus through a company at a similar total rate. The personal tax credit accounts for the taxes that the company has already paid to the Canadian government.

Because we don’t see the company’s tax bill, the dividend tax credit seems like bonus money to us. However, the company’s value was decreased by the corporate taxes paid. Still, since we are investing in companies anyway, I would take getting a credit for the taxes paid over not. It is another reason why Canadian dividend investing is different from foreign dividends, on top of possible FWT issues.

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Eligible Dividend vs Capital Gains Tax Rate

While it sounds like a slam dunk to get a tax credit applied against your income, it is not. Recall, that if we have two companies with the same total return, and one favors dividends, the other will have more of a capital gain instead. While the dividend tax credit lowers the effective tax rate on the full income, only half of a capital gain even counts as income. Whether the eligible dividend tax rate (net of the credit) is lower than the capital gains tax rate varies by province and tax bracket. If you are in a situation where eligible dividends are taxed more than capital gains, seeking them out doesn’t make sense.

Lower Tax Rate vs Tax Deferral

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Capital Gain Tax Deferral

The other issue to consider is that capital gains also benefit from tax deferral. You do not pay capital gains tax before selling, while dividends are taxed in the year received. The growth of the money that is not prematurely paid as tax continues to compound over time. That compound growth is very powerful over a long time frame.

If eligible dividends have a slightly lower tax rate than realized capital gains, the tax deferral can potentially offset this difference. If the eligible dividend tax rate is extremely low, or negative, then no reasonable time frame will make up for that advantage. I will illustrate with a few examples.

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Tax Deferral Beats a Similar Annual Tax Rate

According to the preceding chart, eligible dividends have a lower tax rate than realized capital gains at taxable incomes below $114,750 in Ontario. The tax bracket below that favors eligible dividends slightly. The net tax rate for the eligible dividend is 17.79% compared to 18.95% for a realized capital gain. Let’s say you have $100 invested with a total return of 7% per year, either as only eligible dividends or only a capital gain. The after-tax dividend is reinvested each year. The tax on the accrued capital gain is deferred until the investment is sold. Below is the after-tax value of the investment if it were sold in a given year. In this scenario, that minuscule eligible dividend advantage is overcome by tax-deferred growth after a single year, and the rest is gravy for the non-dividend investor.

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Time Horizon Matters At Lower Eligible Dividend Tax Rates

However, the eligible dividend tax advantage is much larger at lower incomes. For example, in the Ontario tax bracket of $93K to $106K, the net eligible dividend tax rate is 8.92% compared to 15.74% for a capital gain. With that much larger tax rate difference, it would take 20 years for the capital-gain-only tax-deferred growth to overcome that difference.

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“Negative” Eligible Dividend Tax Rates

In the lowest tax brackets of most provinces (excluding Quebec, Newfoundland, and Manitoba), the dividend tax credit exceeds the marginal tax rate. So, it is like a negative tax rate. It can be significant. For example, -7.55% in Ontario for incomes below $53K and -10.29% for incomes below $49K in BC. Those tax savings could provide a significant growth boost if reinvested, which would always beat a capital gain.

That seems great and is often used to build extreme examples for why dividend investing is awesome. However, there are some important nuances to consider. First, it is a non-refundable credit. Therefore, you must have sufficient tax to use it against, or you will lose it. It also takes fewer dividends than you may think to bump you out of those bottom tax brackets. One dollar of eligible dividend increases taxable income by $1.38. This may also increase the claw-back rate of income-tested benefits, such as the Canada Child Benefit (CCB) or Old Age Security (OAS). Those are payments that help people with low incomes, and losing them has the same impact as a tax on personal cash flow.

OAS & CCB Clawback

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Eligible Dividend Gross-Up

Part of why people assume that eligible dividends have the lowest tax rate is that the dollars received are below the tax bracket limits. However, another feature of eligible dividends is that they are “grossed up” by 1.38 to apply to your taxable income. That means a $1000 dividend adds $1380 to your taxable income. This is done to emulate what the pre-tax income would be if you had earned it directly rather than it being earned by a corporation that then pays corporate tax. This tax code acrobatic move does have some practical impacts. Taxable income, not the dollars you receive, is what is used for the tax brackets and marginal rates.

The preceding chart and examples showed income levels below which eligible dividends are taxed at a lower rate than capital gains. However, receiving eligible dividends bumps you up the tax brackets faster than regular income and much faster than capital gains would. For example, if you had no other income, an eligible dividend of $83,152 would result in a taxable income of $114,750 due to the 1.38 gross-up. In Ontario, above that income level, capital gains are more tax-efficient.

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Benefit Clawback (Recovery Taxes)

The gross-up of eligible dividends may also result in faster clawback of income-tested benefits. For example, household taxable income is used for CCB clawback. Personal taxable income is used for the OAS clawback. An eligible dividend reduces those benefits 38% faster than regular income. In contrast, if our investment had accrued a capital gain instead, it would only add to taxable income at half the rate of regular income. Much less of a CCB or OAS claw back, and only when the investment is sold.

Losing money that you would have gotten as a benefit means less after-tax spending money. Functionally, it is like a tax. So, it makes the effective tax rate of eligible dividends higher than you think if benefits are affected. That may not be an issue if your retirement income is below the OAS claw-back threshold, even with the dividend gross-up. However, it is not inconceivable for many.

If the companies that you invested in kept that money rather than paying a dividend, it would have accrued as a capital gain instead. To get the money, you would sell shares. Some of it would be tax-free return of capital (ROC), and only half of the capital gain would be taxable income. For example, selling $100 of shares with a 100% capital gain (you doubled your money) would yield $50 ROC, $25 excluded capital gain, and only $25 of taxable income.

Whether increased recovery taxes from eligible dividends result in more net tax than selling some shares to access money varies. It depends on how generous the dividend tax credit is for the province, tax brackets, and the proportion of the money you get from selling shares that is a taxable capital gain.

Summary

Dividend investors choose to focus on dividend income at the expense of capital gains, given the same risk and expected total return. The impact of that depends on the type of dividend and the account in which it is received. It can vary from good to bad to irrelevant.

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Canadian Dividends

Canadian eligible dividends may be extremely tax-efficient at low income levels. Particularly, in some provinces. However, that can change at higher income levels or if receiving income-tested benefits. Dividends trigger tax annually in the year they are received. In contrast, capital gains defer the tax bill until the holding is sold and the gain realized. Potentially in the distant future. That tax deferral is powerful, as the money not eaten by taxes continues to compound exponentially with time. With equal expected total returns, whether focusing on Canadian eligible dividends is better depends on income level, income-tested benefit clawback, and how long into the future you delay realizing capital gains.

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Foreign Dividends

In registered accounts (tax shelters), eligible dividends result in no Canadian or foreign tax. Neither do capital gains. So, targeting higher Canadian dividends at the expense of capital gains is irrelevant in these accounts. In contrast, foreign dividends face FWT when received inside tax shelters. That may be neutral for US-listed securities in an RRSP because of tax treaty exemptions. However, the FWT is not recoverable elsewhere, such as an RESP, TFSA, or FHSA. Even in an RRSP, the FWT may be lost if a Canadian-listed ETF is used to hold foreign dividend payers. Unless foreign dividend-paying stocks or funds have a higher expected return for some other reason, it is neutral to detrimental to pursue foreign dividends from an after-tax perspective. That is important because you spend after-tax money.

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Are Dividends Really At The Expense of Capital Gains?

This analysis assumes that dividend investing prioritizes dividends over capital gains. However, some would argue that the total return of dividend-payers is higher than that of other stocks. If true, that may mean having more dividends, but also similar or higher capital gains. We’ll examine that assertion in part 4 of this series.