Yeah, I know… talking tax is about as much fun as pulling teeth. But if you’re going to invest in dividend-paying companies, it’s important to understand the tax implications so that you can make the best choices around where to put your money. Today’s post talks about how dividends are taxed in Canada.
Before diving in: if you’re not up-to-speed on what dividends are and how they work in general, click here to read an earlier post I wrote on the topic.
Types of Dividends
First off, there are two main types of dividend: eligible and non-eligible. Eligible dividends are paid out of a corporation’s earnings and profits that have been taxed at the general corporate tax rate. Non-eligible dividends, on the other hand, are paid out of income that has been taxed at the small business tax rate, which is lower than the corporate tax rate. The type of dividend you receive affects how it’s taxed.
What types of companies generally pay eligible dividends?
Most often, companies that pay eligible dividends are larger, more established Canadian companies, such as the Big 5 banks, telecommunications companies, and some energy companies. There are others; these are just examples.
So who pays non-eligible dividends?
Non-eligible dividends are sometimes paid by smaller or privately held corporations. Professional corporations, such as those run by doctors, lawyers and accountants, also sometimes pay non-eligible dividends.
Important: I’m oversimplifying here. There are several factors that go into determining whether a corporation’s dividends are eligible or non-eligible, the details of which are beyond the scope of this post. We’re focused on how they’re taxed – stay with me!
Taxation of Eligible Dividends
Now, let’s talk about the tax rates. Eligible dividends typically receive preferential tax treatment when taxed in the hands of individual investors, because they’re paid out of income that’s already been taxed at the corporate level.
This means that when you receive eligible dividends, you get a tax credit called the dividend tax credit (DTC), which reduces the amount of tax you owe. The actual tax rate you pay on eligible dividends depends on your overall income and which province or territory you live in, but it’s generally lower than the tax rate on other types of income.
Taxation of Non-Eligible Dividends
Non-eligible dividends, on the other hand, are taxed at a higher rate because they’re paid out of income that’s been taxed at a lower rate at the corporate level (it’s all about balance, see?). While you still get a tax credit for non-eligible dividends, it’s not as generous as the one for eligible dividends. Again, the actual tax rate you pay on non-eligible dividends depends on your overall income and where you live.
Remember Your Registered Accounts!
It’s key to remember that, if you hold dividend-paying stocks in a registered account such as a Tax-Free Savings Account (TFSA), a Registered Retirement Savings Plan (RRSP), or a First Home Savings Account (FHSA), you either won’t pay tax on the dividend at all, or you won’t have to pay tax until you withdraw the money from the account. This can be a great way to grow your investments faster over time.
Receiving Dividends in a Non-Registered Account
If you hold dividend-paying stocks in a non-registered account, you’ll need to report the dividends as income on your tax return in the year you receive them. This means you’ll owe tax on the dividends at your marginal tax rate. But remember, you still get that dividend tax credit for eligible dividends, which helps reduce the amount of tax you owe.
One tricky concept to wrap your head around is the idea of dividend gross-up and dividend tax credit. When you receive dividends, the amount you report on your tax return is higher than the actual amount you received. This is because the government grosses up (in other words, increases) the dividend amount to account for the corporate taxes already paid. Then, you subtract the dividend tax credit to arrive at the taxable amount. It might sound complicated (and it is), but tax software or a professional can help you navigate this process.
Wrapping it Up
Dividend taxation in Canada is a bit complex, but understanding the basics can go a long way in optimizing your investment strategy, because dividend-paying corporations can often make great additions to your investment portfolio.
Just remember to consider the type of dividend you’re receiving, where you’re holding your investments, and how dividends fit into your overall tax plan. And if you’re ever unsure, don’t hesitate to seek advice from a tax professional. Happy investing!
