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How Investing Taxes Work (Part 2 - Dividends and Interest)
Continuing on from How Investing Taxes Work - Capital Gains Tax, we will now discuss dividend and interest distribution taxes. For those of you who didn’t read the first article, here is my disclaimer: These tax guidelines described in this post are for Canada only. On top of that, you should consult a tax professional before applying anything you read on my blog and the web in general. With that out of the way, lets start with dividend distribution taxes.
Dividend Taxes/Dividend Tax Credit
What is a dividend?
- Dividends are payments/distributions from public corporations to it’s shareholders. Dividend paying companies typically pay their distributions on a quarterly basis.
Why are dividends tax efficient to shareholders?
- Dividends are tax efficient for shareholders because distributions are paid out with after-tax corporate dollars. Meaning that the company pays out the dividend distributions AFTER it has paid all of it’s taxes to the government. This is the reason why when you receive a dividend payment from a Canadian public company, you are eligible for the enhanced dividend tax credit.
How do I calculate the dividend tax and dividend tax credit?
With the enhanced dividend tax credit, gross up any dividends that you receive (from a Canadian public corp) for the year by multiplying it by 45%.
- Ex: $1000 dividends received in 2006 * 45% = $1450
You add this amount to your income for the year. You take this total amount and figure out your marginal tax rate (taxtips.ca).
- Ex. $55k + $1450 = $56450 (38.16% in NL)
Multiply your grossed up amount by your marginal tax rate
- $1450 * 38.16% = $553.32
Calculate Federal Tax Credit and Provincial Tax Credit
- $1450 * 18.966% (Federal rate) = $275.01
- $1450 * 6.65% (NL) = $96.43
- Total tax payable on $1000 worth of dividends: $553.32 - $275.01 - $96.43 = $181.88 or 18% at my tax rate.
- Or, you can go on the web and find a tax calculator to do it all for you. There is a handy tax calculator on taxtips.ca. Simply pick the province that you are from, enter the information, and hit calculate.
How about dividends from foreign companies?
- Dividends received from foreign companies do NOT qualify for the dividend tax credit and are 100% taxable. For all intents and purposes, you can treat foreign dividend income as interest income.
Other thoughts and tips:
- If you have no other income and single, you can receive up to $48,900 in dividends and pay NO federal tax (~$7k NL Provincial tax). If you have a spouse who also has no other income, you can receive up to $57,800 in dividends and pay $0 in federal tax.
- This is probably why early retirees like Derek Foster have used this strategy.
- However, if you are over 65 the high dividend gross up may negatively affect your OAS payouts. Consult a financial planner before switching to dividend paying vehicles.
Tax on Interest Income
What is Interest Income?
- Interest income is interest received from GIC’s, high interest savings accounts, bonds, and private loans.
How is Interest taxed?
- Interest income is 100% taxable. This means that if you earn $1000 in interest for the year, $1000 is added to your income and taxed at your marginal rate. (40% tax rate = $400 to be paid in taxes - OUCH!)
Where should I keep interest income?
- Interest income, if possible, should be kept INSIDE a registered account (RRSP) due to it’s high taxation.
In Summary:
- Dividend’s received from Canadian public corporations are tax preferred, so you should consider keeping these dividends outside your RRSP. Yes, I know, I should be following my own advice. :)
- Interest income should be kept inside an RRSP b/c of it’s high taxation.
Alright, I think I’ve covered everything that I wanted to. I hope that you learned something. As I said before, I’m not a tax expert so if you see any errors, let me know.
You may also be interested in my article:
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37 Comments, Comment or Ping
1. canadian dollars
Thanks for the post FT! I did not know that foreign dividends are taxed as interest income. Good to know!
Jan 23rd, 2007 @ 8:01 am
3. Shaun
Hi,
Thanks for the two articles on investing taxes. Very helpful! Question regarding the brokerage: Do they withhold taxes (other then RRSP related taxes) when you sell? If so, do they just withhold taxes on your gains? What about losses?
Thanks - Shaun
Jan 26th, 2007 @ 11:54 pm
4. FrugalTrader
Hi Shaun,
When you sell stock for capital gain/loss, whether foreign or not, they will not withhold anything for taxes. You are responsible for paying the taxes at the end of the year.
However, they WILL withhold a % for foreign DIVIDENDS received.
Hope this answers your questions.
FT
Jan 27th, 2007 @ 9:53 am
8. cihanlee
Hi all,
I just had one basic question. Well lets say I have been maxing out my RRSP over the years until my retirement, and what happens if my income at my retirement is not in a lower tax bracket? So when I take out my funds from my RRSP when I am 65, and my tax rate is 40%, how much will I be charged to take out my funds? Thanks, this subject always confused me.
Mar 29th, 2007 @ 12:41 pm
9. FrugalTrader
When you withdraw from an RRSP, it is counted as INCOME for that year. The initial withdrawal will incur a with holding tax:
10% for up to $5k
20% from $5k-15k
30% for > $30k.
So during tax season for that year, your RRSP withdrawals will be counted the same as employment income.
For example, if you made $20k in regular income during your retirement, and withdrew $20k from your RRSP, assuming no other income, you’ve made $40k for that year. Use the taxtips.ca calculator for your province to figure out your tax owing minus the withholding amount from your RRSP withdrawal.
Make sense?
FT
Mar 29th, 2007 @ 12:49 pm
10. cihanlee
Thanks FT, it makes a lot of sense now, appreciate it.
Mar 29th, 2007 @ 1:11 pm
11. Mr. Cheap
The tax implications of interest income has really cooled me off on it (in the past all my investments were in GICs / Canada Savings Bonds). I dabbled in the stock market right before the dot-com crash and lost 75% of my principle (15K). I’m now totally hot on real-estate and dividends (in large part due to the favourable tax treatment) and basically am totally ignoring stocks (my plan is to max out my RRSP with strong high-yield US dividend payers such as Washington Mutual). I know people typically advise that having bonds in the mix is useful, could someone run though the numbers (or point to someone running the numbers) as to why? thanks!
May 24th, 2007 @ 11:45 am
12. Mr. Cheap
I know that the “approved” asset allocation includes bonds, however the 100% taxation and low yields has really scared me off. I used to invest only in GICs and CSB, and have since become very enthusiastic about real estate and dividend stocks. My plan is to max out my RRSP with good US dividend payers (like Washington Mutual right now) and keep most of my non-RRSP investments in good Canadian dividend payers (like Rothmans and Bank of Montreal right now).
Could anyone run the numbers (or point me towards someone who has run the numbers) of what the danger/benefit would be of including bonds in the mix? Obviously I’d be willing to re-think things if interest rates shot up…
May 24th, 2007 @ 11:52 am
13. FrugalTrader
Cheap: In an ideal world, every portfolio should have a percentage of bonds in them due to the negative correlation between bonds and equities. If you are going to purchase bonds, most would recommend that you hold them within your RRSP for taxation reasons.
May 24th, 2007 @ 11:58 pm
14. Ed Rempel
Hi Ft & Cheap,
Bonds are not actually negatively correlated with stocks. That is a popular misconception. They have a relatively low correlation - between 10-40%, depending on which market and which bond market. Including bonds in your portfolio will reduce your risk, but it will also reduce your long term return. Outside your RRSP, the tax cost makes them quite unfavourable.
There are alternatives, however. The correlation between the TSX and bonds is not much lower than the correlation between the TSX and several of the most boring sectors, such as utilities, health care, real estate and consumer staples. Also, recently the TSX has a 30% negative correlation with the U.S. dollar and a low 30% correlation to the S&P500.
The point of this is that you can get similar diversification by carefully designing an all equity portfolio. You need to be cautious with this, since these correlations vary over time and can disappear in a huge stock market crash. However, this is why some equity fund managers have lower risk levels than most balanced funds.
We have found that by carefully defining and measuring risk, we can have 100% equity portfolios for moderate risk clients and 80% equity portfolios for conservative clients - and still remain within their risk tolerance.
Ed
May 27th, 2007 @ 12:02 am
15. Mr. Cheap
FT & Ed: Thanks for your responses!
May 29th, 2007 @ 12:34 pm
16. Dorothy
Just wanted to let you know that your statement about being able to earn $66,000 in eligible Canadian dividends before any federal tax is payable is not correct. That is the amount that could be earned if Alternative Minimum Tax did not kick in at $49,000. The Canadian Tax Calculator on taxtips.ca, at http://www.taxtips.ca/calculators.htm#taxcalculator, calculates alternative minimum tax, so you can see exactly what tax you would pay on your eligible dividends.
Jun 26th, 2007 @ 3:30 pm
17. FrugalTrader
Dorothy! Great point! AMT is something that I don’t know a lot about. Time to do some research.
Jun 26th, 2007 @ 3:38 pm
21. Jim McCartney
I used 20,000.$ in savings to support a line of credit of 30,000$. This money was invested in a registered Canadian company. Will there be tax benefits to me? Like can the interest paid on this line of credit become a deduction for me on my personal IT? Is this a fact or myth?
Nov 9th, 2007 @ 1:28 pm
22. FrugalTrader
Jim, i’m not sure what you mean by using the $20k to support a line of credit of $30k. Does that mean that the actual amount that you borrowed is $10k? Or $30k?
If you use borrowed money to invest (with income potential), then the interest paid on the loan is tax deductible.
Nov 9th, 2007 @ 1:59 pm
23. Jim McCartney
By support I mean, the bank wanted me to invest 20K in a bank GIC. By doing this they extended me a 30K line of credit. My interest payments are running an average of 250.00 per month. My business is not making me any money yet. Slow catching on. Therefore I have no income from my business. I am prepared to perservere for another 8 months and then I’ll have to close the doors. I hope this helps. Thank You for your quick response.
Jim
Nov 9th, 2007 @ 2:50 pm
25. Kyle I
If I invest in a Canadian Based Mutual Fund that pays Dividends, is the money earned from the Mutual fund applied the same as the Dividend tax credit? I dont have to buy 1 particular Canadian stock to receive this do I? And how would you calculate the amount earned if it is not registered as an RSP? Does the company supply you with some form of tax sheet to help in doing your personal taxes? Thanks :)
Mar 23rd, 2008 @ 9:38 am
26. FrugalTrader
Kyle, the mutual fund distribution depends on the mutual fund itself. At the end of the year, you should get a tax form explaining the various distributions from the mutual fund. If they don’t supply the tax info, they should have the info on their website.
Mar 23rd, 2008 @ 9:53 am
27. Rohan
If I reinvest dividends does that mean I do not pay taxes on the dividends?
Mar 24th, 2008 @ 1:40 am
28. DAvid
Yes, you pay taxes on them. Do a web search using “reinvestment dividends taxes Canada” and you’ll find lots of info.
DAvid
Mar 24th, 2008 @ 1:55 am
29. JR
My thoughts on this one, is to buy an underlying security on the US exchanges.
Look for low P/E and high dividend yields.
If the stock has options, even better. Sell a CC in the money (deeper the better) and way out in the option calendar.
Collect the higher dividend rate on the lower cost, and see also if you can get the rollover.
10 - 15% should be easy enough
To find the high dividend stocks, simple google
http://www.dividenddetective.com/big_dividend_list.htm
For low or high P/E ratio’s (toggle)
http://www.schaeffersresearch.com/streetools/premium/toolkit/fundamental/peratio.aspx
Have fun
Apr 8th, 2008 @ 4:22 pm
30. Mark
I was wonder about dividend credits and income. My wife works as do I so how much tax would we pay on the dividends along with our incomes? Is there a table or formula for calculating?
Apr 9th, 2008 @ 4:11 pm
31. Ed Rempel
Hi Mark,
Check out the tax table in the TFSA article: http://www.milliondollarjourney.com/tfsa-vs-rrsp-clawbacks-income-tax-on-seniors.htm .
If your income is between $10-37,000, then dividends have negative tax (dividend income reduces tax) and all brackets other than the highest bracket (over $120,000) are taxed lower than other types of income if you are under 65.The latest budget has set the trend to eliminate this, which we obviously expected, so the negative tax should be gone by 2010. Dividends are taxed favourably, since the corporation that paid them has already paid tax on that income.
Tax on dividends for seniors is mostly quite a bit higher than capital gains, though, and is punitively high for low income seniors - as high as 7%.
Ed
Apr 10th, 2008 @ 12:58 am
32. Ed Rempel
Hi Mark,
Oops, did I say “as high as 7%” for low income seniors? Tax on dividends after age 65 is actually 73% if you have no other income. That is punitively high.
It is generally 30% or higher for anyone over 65 with income over $37,000 or under $15,000.
Ed
Apr 23rd, 2008 @ 2:37 am
33. RG
Hi Mark,
Great articles! I just had a couple of questions
I am interested in buying stock in a Canadian public company, does it matter if I buy it on the TSE or the NYSE to be eligible for the “enhanced dividend tax credit” you spoke of?
Also, what is the scope on “TRUST” funds?
Thanks!
May 1st, 2008 @ 11:39 pm
34. FrugalTrader
RG, only Canadian public companies are eligible for the enhanced div tax credit. US div are taxed like interest, 100% @ your marginal rate.
Some trusts do contain a dividend portion, but most distribute interest and return of capital.
May 2nd, 2008 @ 3:30 am
35. Four Pillars
RG - just to add to FT’s comment - while it’s true that only Canadian companies are eligible for the enhanced dividend, it doesn’t matter which exchange you buy it in (or what currency) - you will own the same company.
ie one share of BMO bought on the TSX is the same as a share bought on AMEX.
Mike
May 2nd, 2008 @ 11:51 am
37. MAC
Banks in the US are getting beat, would this be a good time to buy them.
Example
Bank of America | BAC-N is trading at ~$30.44 and pays a yearly dividen of 2.56 (~8.4% dividen rate of return). Is this correct, seems like this is a good investment even when taxed at 100%?
MAC
Jun 10th, 2008 @ 12:13 pm
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