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 its 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 its 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 38% (2012).
- Ex: $1000 dividends received in 2012 * 38% = $1380
You add this amount to your income for the year. You take this total amount and figure out your marginal tax rate.
- Ex. $55k + $1380 = $56380 (31.15% in ON)
Multiply your grossed up amount by your marginal tax rate to figure out total taxes owed.
- $1380 * 31.15% = $429.87
Calculate Federal Tax Credit and Provincial Tax Credit
- $1380 * 15.02% (Federal rate) = $207.28
- $1380 * 6.4% (ON) = $88.32
- Total tax payable on $1000 worth of dividends: $429.87 – $207.28 – $88.32 = $134.27 or 13.4% on dividends received.
- Or, you can go on the web and find a tax calculator to do it all for you.
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:
- In ON, with no other income and single, an investor can receive up to $56k in eligible dividends and pay very little tax (~$790). If the investor has a spouse who also has no other income, you can receive up to $62k in dividends and pay about $800 in tax.
- This is probably why early retirees like Derek Foster have used this strategy.
- Note though that if you only receive dividend income, you may be subject to alternative minimum tax.
- 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 GICs, 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 its high taxation.
- Dividends 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 its 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.
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