It’s important for investors to realize that there are differences between qualified and unqualified dividend distribution. This becomes apparent come tax time. Knowing the details will help you make better decisions when deciding how to properly allocate your investments and which account you should use. For examples, some investments such are REITs are more appropriate in a tax-sheltered accounts if you want to keep your taxes simple.
Dividends vs Distribution
Let’s explore the characteristics of these two types of dividend payments.
1) Dividends from Common Shares. Most regular dividend payments from Canadian corporations are qualified. This includes the monthly, quarterly or annual dividends paid out by most Canadian corporations.
2) Dividends from Preferred Shares. Most preferred shares dividends are qualified as well.
Qualified distributions are taxed at the normal dividend tax rates and the tax rate will differ based on your marginal tax bracket.
Related: Common Stock or Preferred Shares
This type of distribution is taxed at your normal income tax rate. So in general, the taxes on these unqualified distributions are higher. Here’s a list of some investments that may potentially pay out unqualified dividend distributions:
1) Non-Canadian Dividends. Dividends from foreign companies are not qualified for the dividend tax credit. In fact, not all tax sheltered account can be used to avoid paying taxes on foreign dividends. Dividends from American corporation should only be held in a RRSP account to avoid paying taxes on the dividends.
2) Real Estate Investment Trusts (REITS). These unique assets provide investors with a way to diversify their portfolios by investing in real estate. Many investors use REITs to complement their stock and fixed income assets. Dividend investors like them as well…one of the main benefits is the regular income. REITs are different from other investments because they pay income in the form of rent. But distributions from REITs can be unqualified.
It’s important you look at what the company includes in their distribution. In some cases, you are receiving a return of capital which affects the ACB of your stock. This is why you often hear the rule that you should hold REITs in a registered account such as a TFSA or RRSP (Traditional or a Roth IRA for Americans) to avoid the burden of accounting for income tax purposes.
3) Income Trust. They are not always distributing qualified dividends. They can sometimes have return of capitals along with dividends. Just like REITs, make sure you know if you are receiving a return of capital as it will adjust your capital gains at the time of disposition. You basically need to reduce your purchase cost which could increase your capital gains.
4) Bonds. Bonds do not pay dividends. They pay interest and the payments are considered as such which falls under the marginal tax rate calculation for income. This can include bond ETF’s and bond mutual funds.
5) Mutual Funds or ETFs. These products now have a mixture of dividend and distribution. In many cases, you cannot declare the entire amount as qualified dividends since it may have interest, return of capital, capital gains, or covered calls premiums. Many dividend ETFs or monthly income fund such as BMO Monthly Income Funds will fit this category.
It might seem like a hassle to keep track of all the differences between qualified and unqualified distributions. In general, just remember that investments paying unqualified distributions are better to hold in tax-sheltered accounts. For the most part, it’s best to hold REITs and Income Trusts in tax-sheltered accounts like a TFSA or RRSP. That way you don’t have to deal with the complexity of the taxes.
If the distributions is in taxable accounts, your brokerage firm will provide year-end statements. Those will break down the cash and dividend payments. Bring the statements to your accountant when you do your taxes…and you should be covered.
Readers: Are you careful about what you hold in your specific accounts?
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