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How Investing Taxes Work – Dividend Tax Credit 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 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.

In Summary:

  • 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.

You may also be interested in my article:

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FrugalTrader About the author: FrugalTrader is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 77 comments… add one }

  • Cristian July 18, 2010, 12:36 pm

    Actually I was talking about dividends earned by the corporation. I do pay myself personally dividends from the corporation and I pay almost no taxes on that.
    But I was wondering how are dividends earned by the corporation taxed. I know that interest is taxed at the maximum corporate rate (almost 50%), capital gains are taxed at half of that (because the other half is exempt), but it is not clear how dividends are taxed inside the corporation. I know that there is a gross-up of 45%, after which the tax is calculated (but how?), and then the dividend tax credit is applied.
    Any ideas on this?…
    Thank you,
    Cristian

  • FrugalTrader FrugalTrader July 18, 2010, 1:52 pm

    Here is an article that explains dividends within a corporation:

    https://hermes.manulife.com/canada/repsrcfm-dir.nsf/Public/TaxTopicCorporateTaxation/$File/tepg_taxtopic_CorpTax.pdf

    My understanding as well is that public dividends received within a corporation can be “flowed through” to shareholders and taxed in the hands of the shareholder instead of the corporation. But again, a tax pro should be consulted for the details.

  • FrugalTrader FrugalTrader July 18, 2010, 7:53 pm

    Ok, after reviewing that document, I believe the conclusion is that dividends received within a corporation is taxed with a “part iv” tax which makes it basically the highest possible tax rate. However, it is refundable once the dividend is distributed to shareholders.

  • Cristian July 18, 2010, 8:22 pm

    Thank you FrugalTrader for your input.
    That is what I pretty much suspected, I just didn’t know where to look for this information.
    So dividends received by a corporation are taxed at the maximum rate (like interest income), and then the dividend tax credit is applied.
    I hope I got it right.

    Thanks,
    Cristian

  • Former High-tech Worker August 3, 2010, 4:10 pm

    Be VERY careful of assertions like “you can receive up to $48,900 in dividends and pay NO federal tax”. Your provincial tax may bite you. If you live in Ontario, _no matter how old you are_, you will be dinged for more “Health premium”. After the High-tech layoffs, when I needed to live off my investments, I discovered that with only $16K in real dividend income, because of the gross-up I was both paying income tax (at a marginal rate of 37%), AND I had dividend tax credits I could not use. Anyone living in Ontario (or advising people living in Ontario), should take note. (Hint hint, to all the Alberta-resident tax experts.)

  • David December 8, 2010, 1:06 pm

    Hi everybody

    As I know we pay 100% tax on the interest income received from bonds.

    What if I invest in bond index funds or bond index tracking ETFs
    Will my income taxed as interest or as dividends?
    If invest in bond index funds or bond index tracking ETFs will I be eligible for dividend tax credit?

    Thank you all in advance

  • FrugalTrader FrugalTrader December 8, 2010, 1:38 pm

    @David, if it’s a bond ETF, then the distributions will be in the form of interest.

  • FrugalTrader FrugalTrader December 8, 2010, 1:44 pm

    Actually, a better answer is to visit the website of the ETF and check out their distributions. It’s believe bond etfs can distribute ROC as well, but not certain.

  • David December 8, 2010, 2:16 pm

    Thank you for your replay

    are bond ETFs different from bond index funds in terms of taxes?

    thanks again

  • David December 8, 2010, 2:27 pm

    I mean besides the fact that ETFs can reduce capital gains
    Is the income from bond index funds considered as interest or dividents

  • Kevin January 12, 2011, 11:27 am

    I’m unclear on why holding interest income in an RRSP is favourable. You indicated that interest income is fully taxable, 100% as regular income.

    Withdrawals from an RRSP are … wait for it … fully taxable, 100% as regular income.

    So what’s the advantage?

    This article was written in 2007, before the TFSA, but now that TFSA’s are available, doesn’t it make much more sense to hold interest income in a TFSA, where it’s not taxed at all, rather than inside an RRSP, where it’s taxed 100% as regular income (just as it would be OUTSIDE of an RRSP)?

    • FrugalTrader FrugalTrader January 12, 2011, 11:35 am

      @Kevin, you are correct, but one thing you are missing is the taxation of the contribution amount. With RRSPs, you are investing with PRE-tax dollars (ie. gross income) providing that the tax refund is reinvested, whereas the TFSA, you are investing with after tax dollars (net income).

  • Kevin January 12, 2011, 10:36 pm

    @FrugalTrader:

    Right, of course, but that’s true of ANYTHING you hold in your RRSP, and is not unique to interest-earning instruments. Thus, I’m still not sure why you consider interest-bearing instruments to be particularly well-suited to being held in an RRSP, that’s all I mean.

    Like I said, TFSA’s are a much more efficient shelter in which to hold interest-income instruments, because you’re taking income that would otherwise be taxed at 100% (whether held within an RRSP or in an unregistered account), and reducing its taxation to 0%. You’re saving 100% of the tax.

    I mean to contrast this with, for example, capital gains, which attract 50% taxation in an unregistered account, 100% taxation within an RRSP, and 0% taxation within a TFSA. In this case, you’re saving 50% of the tax (compared to saving 100% of the tax for interest-income items). Thus, it could be argued that interest-bearing instruments are better suited to TFSA’s than RRSPs.

  • Stephen February 19, 2011, 4:53 pm

    Great article.

    I’ve got a question. It was calculated that the total tax payable on $1000 worth of dividents comes to $181.88

    What do you do with this $181.88 amount? Do you go back to step one, and now instead of adding $1450 to $55K, you add $181.88 now?

  • James November 28, 2011, 3:37 pm

    My accountant is away so I’m hoping you can help me with an Interest Income question. I was under the impression that there is a tax credit that actually brings the effective tax rate down substantially on Interest Income.

    i.e – $100 of interest income is initially taxed at 43.7% but after tax credit the effective rate is closer to 26-28%, for a net gain of $72-$74?

    Has anyone heard of this?

    • FrugalTrader FrugalTrader November 28, 2011, 3:44 pm

      @James, if it is truly income from interest (bonds/gics/money market/savings accounts), then it is taxed at your marginal rate. If it’s publicly traded dividends in a non-registered account, then you’re eligible for the dividend tax credit.

  • Yoree January 11, 2012, 9:37 pm

    Would keeping investments inside of TFSA give you a tax free status for dividends that companies pay you?

    • FrugalTrader FrugalTrader January 11, 2012, 10:27 pm

      @Yoree, if the companies are Canadian, then yes, you would not have to pay any tax on them. However, if they are from a foreign country, then there will be a withholding tax. I keep all foreign dividends within an RRSP to bypass the withholding tax.

  • Matt. August 30, 2013, 8:59 am

    I am pretty sure there is also a foreign dividend tax credit as well. For example, if you hold KO in an unregistered account, the IRS withholds 15% but you can claim that on your Canadian taxes.

    In short, for dividend investors, us dividends should be in reap or unregistered, but not in your TFSA. Hold your Canadian dividend companies in any of them, but especially your TFSA.

  • FrugalTrader FrugalTrader August 30, 2013, 10:14 am
  • Javed September 18, 2014, 2:13 pm

    If I buy Royal Bank shares in NY with in my US $ TFSA account.
    Would I have to pay the with holding tax on dividend?
    Would I get the dividend tax credit?
    How the capitol gains will be taxed by the US.

  • FrugalTrader September 18, 2014, 2:57 pm

    @Javed, the withholding tax will automatically come out of your account. There is no dividend tax credit for US stocks no matter the account. There is no capital gains tax within a TFSA.

  • Sam March 26, 2015, 6:37 pm

    Hi,

    I would like to borrow money to buy Canadian Mutual funds in a non-registered account and would like to know if I can dedict the intrest paid on investment loan is tax deductable or not ?

    Thanks,

  • Ed Rempel March 26, 2015, 7:47 pm

    Hi Sam,

    There should be no problem with tax deductibility for you. Essentially any mutual fund should be deductible, as long as you do not take tax-free distributions (such as from a T8 fund).

    Ed

  • Sam March 28, 2015, 5:59 pm

    Thanks Ed. Is it true for Canadian ETF’s as well ?

    Thanks,

    Sam

  • Ed Rempel March 31, 2015, 12:10 am

    HI Sam,

    I am not an expert on ETFs, since I personally would not buy one. My understanding though, is that most may be fine but it is harder to be 100% sure. All mutual funds allow you to reinvest all distributions, which means you definitely have no issues with ROC reducing your tax deductibility. My understanding is that you don’t have that option with ETFs.

    If the ETF buys some REITs, for example, you could have some ROC in a distribution passed on to you.

    The way to maintain full deductibility is to make sure that 100% of all cash paid out by an ETF is either used to reinvest or to pay onto the investment loan. If you receive distributions that you think are dividends and you use them for another purpose, and then you find out at the end of the year that they included some ROC, then your investment loan is no longer 100% deductible – and it’s up to you to calculate properly what portion of the interest is still deductible and to be able to prove your calculation to CRA.

    Ed

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