Every year, like clockwork, 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 have a better income 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 form 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 that differ between dividends and distributions. The below information is specific to what is considered a dividend and not a distribution.
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.
Dividend Tax from US Corporations
US dividends from US corporations are usually subject to a withholding tax from the respective government with the exception of the dividends from investments held in an 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 dividend from US corporations
- 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%.
Dividend Tax from Foreign Corporations
If the dividends come from a non-Canadian and non-US corporations, there will be withholding income tax. Make sure you know why you want to hold those investments.
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 slip.
- 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 choose the type of investments.
While it’s important to understand your dividend income tax, it’s also critical that you understand how to be tax efficient across your finances.