Tuesday, 4 August 2009

Three Reasons to Love Dividends

Dividend stocks are an attractive proposition these days for several reasons, though such attractions are always tempered by potential downsides.

1 - High Yield
Despite the tremendous drop in share prices many solid companies are still making profits and are continuing to pay out some of those profits as dividends. As a result the return from dividends alone, defined as the Dividend Yield (the annual dividend / current price as a percentage) has gone up to historically high levels. For instance, Bank of Montreal shares (symbol BMO) are paying out $0.70 per quarter or $2.80 per year, which yields over 5% on recent prices around $51 per share. The iShares TSX 60 Index ETF (symbol XIU), a combination of the 60 largest companies on the Toronto Stock Exchange yields about 3%.

Risk: The big unknown is whether the dividends will be maintained or cut in response to the recession. Companies may state their intention to keep paying out but the investor is wise to check outside commentaries, read financial reports and form an independent opinion.

Tax Advantages
When investing in a non-registered taxable account, one needs to be aware of how income taxes affect dividends. There are strong pluses but a few caveats and potential downsides exist too.

2 - Low(est) Tax Rate Type of Income
For all but taxpayers in the highest income brackets, dividends have a lower tax rate than interest and capital gains. The effect is most pronounced at lower income levels and peters out in most provinces as taxable income (total income, employment earnings plus investment income minus deductions like RRSP contributions, child care, moving, education, union and other expenses) exceeds $70,000, though that varies considerably by province. Some like Alberta, Ontario and BC still show a much lower tax on dividends at $100,000 income while in Nova Scotia the superiority ends at around $90,000. Enter your 2008 income in the Ernst and Young Personal Tax Calculator to see what it is for your province.

3 - Extra Dividends Can REDUCE Taxes for Lower Income Taxpayers
Tax rates on dividend income are less than zero, i.e. negative for the lowest tax bracket of $36-37,000 (in 2009) in most provinces, except Nova Scotia and Newfoundland at c. $30,000 and the real outliers of BC at $71,000 and Quebec at $0. Detailed tables are available at TaxTips.ca's Provincial Personal Rates page. When filling in your tax form, there is a dividend gross up and tax credit that can offset other income taxes so that you end up not paying any tax on the dividend and paying less on other income. TaxTips.ca explains with an example here.

Tax professional Tim Cestnick wrote a column titled How to take advantage of the dividend tax credit in GlobeInvestor in which he noted that a BC taxpayer with no other income but dividends could earn up to $70,000 without paying tax. TaxTips.ca shows how much in dividends could be earned tax-free in other provinces.

Risks: Several realities may temper the benefit of the "use dividends to get tax-free income" idea.
  • Alternative Minimum Tax may kick in - note on the page cited above, TaxTips.ca said that at around $50,000 in dividends and there is no other income, you may have to pay tax anyway ... but at 3% yield, that would mean having a taxable portfolio of almost $1.7 million, which excludes most individual investors.
  • the dividend gross up procedure increases net income, which is used in calculating government benefits like OAS, GIS and Child Care and could cause loss of some portion of benefits, i.e. reduced income
  • the federal government has announced the progressive reduction in the tax credit for dividends such that by 2012 the negative tax rate on dividends will disappear - again TaxTips.ca has a handy table with the numbers. Dividends will still be taxed less than capital gains or interest however.
The above is for information only and is not to be construed as advice. When in doubt consult a professional to ensure you get it right.

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