Investing Income Tax – Understanding Dividend Tax

Dividend TaxEvery year, like clock work, we all have to do our taxes. For many like me, we have to report our dividends and pay our taxes on this amazing passive income. The great thing about dividends is that it’s a passive income and it has a preferred tax rate compared to interest or regular income. Only capital gains has a better tax rate but you have to sell your investments to access your money. (Note that the amount of tax you pay really depends on all your income.)

Related: Capital Gains Income Tax

For the most part, my investments are mostly tax sheltered but I do have some money in a non-registered account through RBC Direct Investing, Computershare and CanStock Transfer Agent. For the most part, I receive a T5 forms for all the shares in my name and those in my kids’ name (held in trust).

Understanding Dividend Tax

Let me be clear on a few points before we go over the math. There are a number of rules against different dividends and distributions.

Canadian Dividend Tax

Dividends paid by Canadian corporations are paid with after tax dollars and to avoid double taxation in the hands of investors, a preferred rate is applied. There are two concepts that come to play with Canadian dividends:

  • Dividend Gross Up: A strategy to estimate the value of the dividends before the corporation paid taxes. The gross up has been going down in the past few years.
  • Tax Credit: The federal and provincial government each have a tax credit that is applied against the dividend gross up income tax.

The dividend tax is only payable on dividends earned in a non-registered account.

US & Foreign Dividend Tax

Dividend Snapshot
US and foreign dividends are usually subject to a withholding tax from the respective government with the exception of the dividends from investments held in a RRSP. The distinction of accounts, even the tax-free accounts, is important as the only account where there are no taxes on US dividends is the RRSP. If you hold US stocks that pay dividends in your TFSA or RESP, it will be subject to the withholding tax.

US & foreign dividend tax summary:

  • RRSP: No taxes on US and Foreign Dividends
  • TFSA: Withholding taxes apply
  • RESP: Withholding taxes apply
  • Non-Registered: Withholding taxes apply

The three tax-free accounts can still hold foreign stocks with no taxes to be paid on capital gains so you can still diversify and not just rely on Canadian stocks.

The US withholding tax rate is 30% unless you file a W-8BEN form with your discount broker which brings the withholding tax rate to 15%.

Income Trust Distributions

I want to discuss income trust distribution as it is often grouped with dividends but it actually has different tax rules to the distribution. The reason for the different tax rules is due to the different income you generate from the income trust. Distributions are reported in a T3 slips.

  • Interest & Other Income: Taxed at your marginal tax rate
  • Canadian Dividends: As explained above.
  • Return of Capital: It reduces your adjusted cost basis (ACB). It basically reduces your initial purchase price on your shares. It’s an accounting pain to be honest if you hold REITs in a non-registered account.

Calculating Dividend Taxes

Now that we understand how the taxes are applied, let’s look at the math.

Taxes = ((Dividends * Gross Up) * Marginal Tax Rate) – ((Dividends * Gross Up) * Tax Credit)

Since 2012, the gross up at the federal level has been 38% down from 45% back in 2009. I don’t expect anyone to have to do the calculations on their own unless you still file your taxes using a paper form. All you need to do is enter the numbers in your T5 form but understanding why dividends have a better rate than interest or income is important as you chose the type of investments.

Readers: Are you still interested in holding US stocks in your TFSA?

Image: digitalart / FreeDigitalPhotos.net

7 Responses to "Investing Income Tax – Understanding Dividend Tax"

  1. Just because you buy a stock on a US stock exchange does not mean it is a US stock.
    I used to own (just sold) RDS – Royal Dutch Shell and it was subject to a US withholding tax even though it was in my RRSP.and was on a US exchange.
    The other exception to the no-tax rule is MLP – Master Limited Partnership.
    I also used to own KMP – Kinder Morgan Partnership – in my RRSP and it gets dinged quite heavily, almost 40% even within the RRSP. MLPs usually paid nice dividends but losing over a third of the dividends causes them to lose a lot of their luster.

    Reply
    1. I agree that not all stocks on the US exchange are US but it is considered a foreign stock for Canadians and the same rule applies.

      Thanks for sharing about the MLP, I actually wasn’t aware. I guess they pay distribution and not qualified dividends.

      Reply
      1. Ricardo is right about the US MLP. It is subject to tax withhold regardless the account type, as they are not taxed at the corporate level, and all revenues are passed to unit-holders as distributions to be taxed at unit-holders hands. And yes they pay Distributions not Dividends..

  2. I do hold some blue chip US dividend paying stocks in my TFSA.

    I am fortunate to be very young and already investing, currently 24, and will have a nice pension available to me by the military, reaching retirement of 25 years service by the time I am 45 years old.

    Currently my goal is to be able to live off both my pension and cash from dividends, but not quite sure when… depends on how I want to live when I get to that point in my life

    Im having a little trouble deciding wether to hold these US blue chips in a RRSP or not.
    I understand the tax implications for all the accounts, but don’t like the idea of locking equity in a RRSP, since I am not sure what my income will be in retirement, or if i’ll even be fully retired.

    On the other hand, the tax benefits are impressive… not sure im making a big mistake by not using the RRSP…

    As always, love reading the articles here.

    Reply
  3. Holding US stocks outside of an RRSP, including a TFSA, will require your to file with the IRS. I have nothing against that, except the paperwork. I use the KISS method – Keep It Simple Stupid
    If you are at ease with the dual filing then go for it.

    Reply

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