If your investments include RRSPs, TFSAs and taxable accounts, asset location is an important consideration. The returns of various asset classes—such as bonds, Canadian stocks, and foreign stocks—are treated differently under tax law. So by selecting the most tax-advantaged assets for your non-registered accounts, you should be able to keep more of the returns for yourself.
As most investors know, eligible dividends from Canadian companies are taxed at a much lower rate than interest and foreign dividends. In fact, for Canadians who make less than $40,000 or so, the tax rate on dividends is actually negative, which means you can use them to lower the amount of tax you pay on other income. That’s why the conventional wisdom is that Canadian dividend-paying stocks are the most tax-efficient asset class.
That is true in many cases, but the dividend tax advantage is often overstated. For taxable investors who have above-average incomes, it may not make sense to focus on dividends at all.
Dividends v. capital gains
Recall that stock returns come in two flavours: dividends and price appreciation, or capital gains. While dividend investors unleash the hounds whenever I make this argument, these are two sides of the same coin: a company’s earnings can either be reinvested (which causes the value of the stock to rise) or paid to shareholders as cash dividends (which causes the stock price to fall), or some combination of both. Ignoring taxes, a stock that appreciates by 5% and pays no dividend delivers the same return as one that appreciates just 2% but also pays a 3% yield.
Of course, you can’t ignore taxes if you’re investing in a non-registered account, and for Canadians with relatively low incomes, these two types of returns are taxed very differently. For an Ontario taxpayer with an income of $42,000 in 2012, the marginal rate on eligible Canadian dividends is just 3.8%, while the rate on capital gains is more than 12%. (My source for all tax rates in this post is TaxTips.ca). Obviously, someone in this situation would prefer Canadian equities that paid a high yield at the expense of lower price appreciation, and therefore might reasonably choose a dividend-focused ETF in a taxable account. Something like the iShares Dow Jones Canada Select Dividend Index Fund (XDV) would be an excellent choice.
For higher-income Canadians, however, the difference in tax rates between eligible dividends and capital gains is much less significant. In Ontario, for example, with an income of $81,000, eligible dividends are taxed at 19.9%, while the rate on capital gains is actually a bit lower at 19.7%. And at the highest tax bracket, capital gains are taxed at a much lower rate: for income over $132,000, the rate is approximately 23% for capital gains and 30% for dividends.
The differences are similar for high-income investors in British Columbia, Manitoba, and Quebec. They are smaller in Alberta, Saskatchewan and the Atlantic provinces.
Should you really prefer dividends?
Equity investors who are building index portfolios in taxable accounts should think carefully about whether they really should focus on Canadian dividends. If you’re in a high tax bracket, it might make sense to look at Canadian equities that pay less in dividends and deliver most of their returns in the form of price appreciation.
As you can see from the above chart, the iShares Dow Jones Canada Select Growth (XCG) has seen much greater price appreciation than the than the iShares Dow Jones Canada Select Dividend (XDV). However, because growth stocks, by definition, don’t pay generous dividends, the yield on XCG is only about 0.7%. Meanwhile, XDV pays about 3.8% in dividends annually.
As it turns out, over the last five years, the two ETFs delivered virtually identical total returns: 1.85% versus 1.87% annualized. However, investors in a high tax bracket would have kept more of XCG’s returns for themselves. Because capital gains are only taxable in the year they are realized (that is, when you sell at a profit), an investor who held XCG in for the whole five years would have only paid tax on that very small dividend.
The information in this post should in no way be considered tax advice for individuals. Always consult an accountant or qualified advisor before making any investment that has tax consequences.
For high income individuals does your analysis in favour of capital gains support holding HXT since the total price appreciation is delivered as capital gains (and no dividends paid) by a swap mechanism?
@KD: It will depend on individual circumstances, but in general, yes. In fact, that is precisely the reason that HXT was created. The tax savings would potentially be even greater for HXS (which tracks the S&P 500), because US dividends are fully taxable, while capital gains on US stocks are taxed at the same rate as any other capital gains:
“As it turns out, over the last five years, the two ETFs delivered virtually identical total returns” I think that true buy & hold dividend investors maybe don’t see it that way Dan. At the end of the 5 year period XCG made much less in terms of a tangible return while sometimes contributing nerve racking annual beta. I think that certain temperaments need annual tangible returns to offset the volatility to calm their nerves and having annual dividends piling up in their cash accounts produces a calming effect (and is healthier than vodka) for certain investors which outweighs the tax implications in larger accounts and prevents them from abandoning their investments. XCG lost almost 12% last year; hard to stomach for weaker temperaments like myself!
1st: A lot of studies have demonstrated that dividend paying stocks (as a group) have done a lot better over the long term than none dividend paying stocks (as a group).
2nd: I don’t understand your statement. I have yet to meet someone investing in stocks simply for tax considerations. Dividends are a bonus; an important one. As for myself, I keep some of my canadian div. stocks inside my TFSA (I can withdraw my dividends tax-free) and my US div. stocks inside my RRSP (to avoid the withholding tax).
3rd: Why not use CDZ instead of XDV ? CDZ has a 4.6% – five years total return.
@Jon: Thanks for the comment. I don’t disagree that dividend stocks are often less volatile, and that this can have a lot of value for an investor from a psychological standpoint. I’m simply stating the fact that high-income investors may pay a price for that calming effect.
Remember, too, that dividend stocks fall in and out of favour. Last year XDV did extremely well compared with XCG, but in 2007, XCG was up 21% while XDV lost about 1%. Even in 2008, XCG (very slightly) outperformed XDV.
@Eric: I don’t mean to sound like a champion of growth stocks (which historically have delivered much lower returns than value/dividend stocks), but simply want investors to be aware that there are some situations where price growth is preferable to dividend income.
Re: “I have yet to meet someone investing in stocks simply for tax considerations.” Lots of people buy Canadian dividend-paying stocks for their tax advantage. And investors who have maxed out their RRSPs and TFSAs have no choice but to invest in taxable accounts, so they need to understand how different types of investment returns are taxed. Many do not realize that the situation is dramatically different for low-income and high-income investors.
CDZ is a good complement to XDV but, in my opinion, not a good substitute. More here:
@CCP, Thanks for this Dan, I think a lot of personal investors neglect tax consequences because they either house all of their investments in RSP and/or TFSA so no consequences to consider, or because the sums invested in taxable accounts are small. But I think managing investments in taxable accounts in most tax advantaged way is crucial, not doing so can be a big drag on returns. My only comment on your article is that another dimension is in fixed income – Claymore’s fixed income ETFs that use forward agreements to characterize distributions as capital gains rather than income are likely to outperform plain vanilla bond ETFs within a taxable account. I say likely because I’ve never tested XBB vs. CAB in a taxable account setting, and I recognize the forward agreements are expensive and push up MER.
@DM: Yes, there are several innovative ETFs available for taxable investors. I plan to look at some of them in a future post. In the meantime:
Great post Dan! It seems many great minds have been converging on this very topic :)
A couple of recent related articles on the topic of asset location…
Yours Truly | Should you hold bonds in taxable accounts?
Jamie Golombek | Rethinking asset location
@CCP: I am looking forward to the “ETF’s Available for Taxable Investors” article.
This has triggered me to take anther look at my taxable account. I currently have 40% of my taxable account in XBB. So I’m paying the highest tax, would those advantaged ETF’s be a better option for me? My other option is to overexpose myself to risk in equities (and I doing so wrecking my allocations). Then I also have VTI and VEA which are exposed to the 15% US withholding tax (that I hear I can get back somehow). What sorts of options do I have to help my tax situation for these? I believe all my equities are capital gains based so getting taxed fully for foreign dividends isn’t a concern.
@Dan H: Thanks for the great links. Yes, the situation certainly changes when cash is yielding 1.5% and bonds less than 3%. A $10,000 cash investment, at the highest tax bracket, would lose less than $75 to taxes. Is it really worth using RRSP or TFSA room for savings that low?
@SterlingF: It’s possible that CAB would be preferable to XBB in a taxable account (that is certainly the theory). But I will look at this in more detail in a future post. But you’re right to be wary of substituting dividend stocks for bonds:
In general, foreign stocks are best held in an RRSP if you have room, because in a non-registered account foreign dividends are fully taxable and subject to the withholding tax. This post may help get you started:
@ccp: take a look at CDZ; the criterias are different for 2012. In my opinion CDZ is a better choice than XDV.
@CCP: I don’t have any RRSP room (good problem to have) so I can’t any move money into my RRSP from my taxable account. I keep both accounts separate in terms of asset allocation and I suppose if I would have thought of them as one I could have better utilized my RSP for foreign investment and invest heavier in XIC in my taxable.
I’m curious now, will I be receive dividends and/or capital gains from VTI and VEA? I was thinking it would just be capital gains but because they hold so many stocks some of them must be dividend paying.
@Sterling: Yes, both VTI and VEA pay dividends. VTI pays them quarterly, and VEA pays annually.
These dividends are fully taxable. Assuming a 2% yield for VTI, you’d receive $200 a year on a $10,000 investment. If you lose 45% to tax, that’s $90, or a drag of 0.9% annually.
@CCP: Enjoyed your post, as always. For older investors dealing with the OAS clawback, the benefits of capital gains over dividends are greater. The 15 percent clawback is applied to grossed-up dividends but to only half of capital gains. Tax-advantaged bond ETFs (like CAB) seem to be a good choice for seniors trying to reduce both clawback and equity risk, as long as the MER is not too much of a drag. Hope you can say more about this in a future post.
Deferred capital gain tax in combination with the time value of money can make capital gain much more tax efficient than frequently taxes dividends.
Good post, and comments. I don’t mean to oversimplify the subject, but receiving regular dividend cheques in the mail is a great sense of accomplishments. And the bigger they are, the better it is. Think about it!
Your point is well taken, even though I am not in a high tax bracket:
“If you’re in a high tax bracket, it might make sense to look at Canadian equities that pay less in dividends and deliver most of their returns in the form of price appreciation.”
@Michel – I’m with you!
Great post with lots of information here Dan.
As a complete aside, what the heck is up with B.C.’s tax brackets for 2011? How many people wind up falling into “the over $83,001 up to $83,088 tax bracket?” If you fall into that range are you middle class?
SterlingF and others:
I have an allocation to bonds in my taxable account – but almost all of TFSA, RSP and RESPs are bonds or cash. I also hold dividend stocks in taxable but not US.
But overall asset allocation is what I am comfortable with.
You have to look at your risk profile. I am getting concerned at all the talk that compares the yield from dividend stocks to government bonds or high grade corporates.
They are ENTIRELY different from a risk perspective.
Advisor types will talk up this kind of thing. But so what if you have a 4 or 5% yield when that capital is being exposed to a potential 20 to 40% drawdown and who knows what in future? This is not to say that one should not own risk assets and ones that pay dividends – it is just that you cannot substitute one (stocks) for the other (bonds) in any asset allocation – ever, whatever the yield.
@Andrew: Thanks for making an extremely important point. It is unusual for average dividend yields to be higher than those of 10-year bonds, but as you say, that is a terrible reason to choose stocks over bonds. I have written about this in the past:
@Andrew & CCP: In my previous posts I didn’t mean to imply that I wanted to replace bonds with dividend stocks specifically but rather adjust my allocations to make it more tax efficient. I was initially happy with my taxable account being split 60% equities and 40% bonds with 40% of my equities being US ETF’s. I would be comfortable with a 70/30 split (like my RRSP) and put the extra 10% of equities into a Canadian ETF instead of splitting it up with US as well. At least now I realize how I have things set up isn’t the most tax efficient. Full taxes on bond gains, US withholding tax and full taxes on foreign dividends (which is probably the same thing), all that adding up to 80% of my taxable account…ouch. Maybe after I read up and understand all my options (with all your help I hope) I will decide to not change anything b/c I’m happy with the allocations but with 80% of my account being that way that’s probably not likely.
@Andrew & CC: Interestingly, Burton Malkiel (author of “A Random Walk Down Wall Street”) is now advocating that older investors abandon a portion of their bond allocation in favour of dividend-paying stocks. He calls this a “dividend-substitution strategy”: http://www.indexuniverse.com/sections/features/10809-malkiel-dividend-stocks-good-for-seniors-.html?start=2
@Chris: Thanks for the link; it’s an interesting interview. If you pressed me, I wouldn’t object too strongly to the idea of moving a portion of one’s bond allocation into blue-chip dividend stocks. But it would only a be small portion, and it would have to come with the full understanding of the risk.
I find it odd that Malkiel would recommend emerging market bonds and dividend stocks, based on the principles of Modern Portfolio Theory espoused in “A Random Walk Down Wall Street.” Two points come to mind. First, the aforementioned book is a rather deep tome that any serious investor should work his or her way through. Second, I’m starting to wonder how piling on the dividend stock bandwagon is going to work out for folks in the long run. Malkiel’s chapters on investment history cover some possible outcomes. And the topic is also one of the pillars covered in Berstein’s classic The Four Pillars of Investing. I hope dividend investors don’t meet the same fate as the tech hungry investors of the ’90s. Time will tell. Its still early in the game.
Thanks for this very interesting article.
I own a company (LTD) that has excess of money from the previous year. I don’t need money this year. What are the best investments from tax point that I should hold in my company’s account? Thanks.
For those that are not opposed to active managers there are mutual funds that have the ability to convert annual cap gains, dividends and income into ROC and defer all annual distributions. Nothing is free in life so the amount of the distributions reduce the ACB, when the position is sold you would be paying capital gains tax on the difference between the NAV and the reduced ACB. To my knowledge, limited as it is, there are no ETFs that can do this at the moment.
A mix of these type of funds can produce a risk appropriate portfolio.
@Bluehorshoe: The Claymore Advantaged ETFs do this to some extent. Not all of the distributions are ROC, but many of them are. In other cases, interest or foreign dividends are distributed as capital gains.
What do you think of the new dividend etf from bmo: ZDV ?
Would it de a better complement to CDZ than XDV
@Donat: I’m not a big fan of ETFs that do not track an index and do not disclose their methodology. ZDV fits that description:
That said, ZDV does seem to have better sector diversification than XDV.
Besides Canadians with low incomes, there are a few specific situations where one could prefer investing in Canadian equities with high yield dividends, such as:
– Someone without a pension plan who cannot invest in RRSP (or doesn’t want) and who plans on living off eligible dividends at retirement. Depending on the province, you can receive up to 60k of eligible dividend income and pay almost no tax if you don’t have any other income. (http://www.dividendninja.com/susan-p-brunner-interview-1)
– A business owner, or incorporated professional, investing inside his corporation could decide to flow through the eligible dividends from Canadian equities to a low income spouse.
I have a few questions. one of the financial advisor told me that I can borrower a virtual investment loan paying 4% interest and do investment in some funds such as Aegon fund (imaxx canadian fixed pay) paying dividend 8%. The advisor told me that the dividend payment is more than sufficient to pay off the investment loan leaving extra cash and I can reinvest. the plan sounds great as it generates money for me in the long run. Now, my only concern is how will I be taxed on the dividend? my gross income is around $50K annual. i just want to know if the taxed on the dividend will make my situation worse or not. I did some reading and got confused with dividend gross up & dividend tax credit. for example, how much tax for a person making $50K annual with $8000 yearly dividend?
@Helen: No respectable financial advisor would recommend borrowing money to generate income like this. The only person who is likely to profit from this arrangement is the advisor. You cannot count on 8% return from stocks, and even if you could your returns will be reduced by interest on the loan, fees and taxes. I urge you to get a second opinion. Please.
By the way, a real adviser would be able to answer your questions about how you would be taxed. It is a bad sign that yours cannot.
@Jaz: In the situation of a professional corporation investing in Canadian equities, how is the dividend and capital gain treated tax wise? I thought the preferential treatment of revenue gain within a corporation was only with respect to professional income. If capital gain and dividend is received by a corporation, what is the tax rate paid by the corporation? Is it the same rate as any income? (I understand that the corporation can then pay out dividends at low tax rates to its sole or other shareholder).
If my husband and I have an incorporated company (we’re the only shareholders), is it better to pay ourselves in Dividends or salary? We’re thinking that Dividends is more tax effective … or a combination? We’ve been advised to stick with salary, but I’m not believing it. CPP is not an issue… we’ll do our own investing.
@Rosanne: I did an article on this issue that you may find helpful:
Why does it say on the iShares website that XDV is not eligible for registered plans? What does that mean? Can we not buy it in an RRSP account? Here is what is displayed on the page:
Distribution Information as of 27-May-2013:
Eligible for Registered Plans No**
Distribution Frequency Monthly
Last Distribution per Share $0.07819
Distribution Yield 4.15%
Last Date Paid 31-May-2013
@HH: I hadn’t noticed that before, and in fact, many other iShares ETFs have the same notice on their web pages. You can certainly buy these ETFs in an RRSP, so I’m not sure what that means. You may want to email iShares for an answer.
Good afternoon Canadian Couch Potato blog contributors,
I have recently finished an index investing course on Udemy. I live in the province of Saskatchewan within Canada and am 27 years old. My reason for investing is to increase my wealth in order to become financially independent. My vision is to invest for the long term and grow my wealth along a 20 – 30 year time horizon. However, I also intend to ensure that I receive regular (hopefully monthly) dividend payments some of which I would reinvest but some of which I would keep to fund my projects and cover living expenses. As per the course, due to my age and attitudes toward investing I am in the high risk portfolio bracket. According to the lessons in the class, the division of money among the various asset classes are as follows: 10% long term bonds, 10% Reits, 30% U.S.A Large Cap stocks, 20% International Developed Stocks, 15% Emerging Market Stocks, 10% Mid Cap stocks, and 5% Small Cap stocks. I have two questions for you, if you would be so kind:
1. Do you feel that this division of assets will help me move toward my goal mentioned above? Especially, in terms of generating passive income on a monthly/regular basis?
2. Is there any individual or service (low cost or free of charge) such as a robo advisor that can provide guidance on this matter to enable me to view the areas where I need to make adjustments in order to move toward my goal?
Thank you for all your time and attention!