How Are Dividends Taxed? How Can They Lower Taxes In Retirement?

Owen Winkelmolen

Fee-for-service financial planner and founder of PlanEasy.ca

Dividends from Canadian corporations receive some special tax treatment that can make them an attractive investment in non-registered accounts. This special treatment means that they can help lower your average tax rate, especially in retirement.

But this special tax treatment makes it a bit confusing to understand how dividends are taxed. To calculate tax on Canadian dividends there are things like “gross ups” and dividend tax credits to consider.

Despite the extra confusion caused by this special tax treatment it can be very attractive to invest in Canadian companies. For most people there is a significant tax advantage when receiving Canadian dividends. For example, in Ontario, a retiree in the lowest tax bracket will experience a negative tax rate on eligible dividends!

The way these eligible dividends are taxed can help offset other income from CPP, OAS, pensions and RRSP withdrawals. With a bit of tax planning this advantage could add thousands in after-tax income for a retiree.

In this post we’ll look at how dividends are taxed, the difference between eligible and non-eligible dividends, and we’ll look at an example of how eligible dividends can help lower taxes in retirement (all the way to zero!).

Lastly, we’ll also look at how the dividend gross up can also trigger OAS clawbacks for high income retirees. A surprising negative of the way dividends are taxed (although it’s still an attractive form of income).

 

 

What Are Dividends?

Before we get into how dividends are taxed, it’s important to understand what dividends are in the first place. Dividends are payments from a corporation to its shareholders. Typically dividends represent a portion of the profits that a corporation has earned.

A corporation could be a private corporation or a public corporation. It could be a Canadian corporation or a US/Global corporation.

Dividends are also paid by mutual funds and ETFs. Mutual funds and ETFs can hold many different companies and accrue dividends from all of the different investments they own. An index ETF would own a small portion of hundreds or even thousands of companies. As those companies pay dividends the ETF adds them up and then pays them to ETF owners. The idea is the same as owning a company directly, but there is a middleman in between.

The way dividends are taxed will depend on where the dividend came from, what type of corporation it is, how that corporation is taxed, and if that corporation is based in Canada.

Typically dividends being paid by a mutual fund or ETF retain their form. The dividends just “flow through” the mutual fund or ETF. This is important for tax treatment later, especially when an ETF owns multiple types of investments that pay different forms of income. This could result in a dividend from an ETF that has many different parts.

 

 

Eligible vs Non-Eligible Dividends

When it comes to Canadian dividends, the difference between eligible and non-eligible dividends is very important because they are each taxed differently. When a Canadian corporation issues a dividend they have to say whether it is an eligible dividend or a non-eligible dividend.

For the most part, dividends issued from a Canadian controlled private corporation will issue non-eligible dividends, as long as their income was taxed at the small business tax rate. This could be your typical small or medium sized business in Canada.

Large public corporations in Canada on the other hand will typically issue eligible dividends. These are companies like Bell, Royal Bank etc. (Private Canadian corporations may also pay eligible dividends when they pay tax at the general corporate tax rate)

We care about eligible vs non-eligible dividends because they receive different tax treatment. They each have different “gross-up” rates and different dividend tax credit rates (more on this in the next section). These gross-ups and dividend tax credits are important when doing long-term tax planning.

DIY investors who are invested in Canadian equities will likely be receiving eligible dividends (although it is possible in some circumstances to receive non-eligible dividends from a public company in Canada).

 

 

How Are Dividends Taxed?

The interesting thing about Canadian dividends is how they are taxed. They receive a special tax treatment that could be both helpful or harmful in retirement. But before we get into tax planning opportunities let’s first look at how dividends are taxed.

Example for an eligible Canadian dividend using the lowest tax bracket in Ontario
Eligible Canadian dividends experience what is called a “gross up”. The actual dividend amount is increased by 38% (for the 2019 tax year) and its this grossed up amount that gets included in an individual’s income. So if you receive $100 in eligible dividends in 2019 then the actual amount reported in your net income for tax purposes is actually $138. Even though you only received $100 in cash, your net income increases by $138 (this is important for government benefit calculations, more on this later).

To offset this gross up there is a special non-refundable dividend tax credit. For eligible dividends the Federal tax credit is 15.0198% of the grossed up amount (there is also a provincial tax credit too, for example its 10% in Ontario). This tax credit reduces the tax owing on the grossed up dividend.

This is how it works for the lowest tax bracket in Ontario…

 

Cash Dividend: $100

Grossed Up Amount: $138 ($100 x 138%)
Tax Rate: 20.05% (Combined Federal and Ontario)
Tax Before Credit: $27.67 ($138 x 20.05%)

Dividend Tax Credit Rate: 25.0198% (Combined Federal and Ontario)
Dividend Tax Credit: $34.53 ($138 x 25.1098%)

Tax After Credit: -$6.86 ($27.67 – $34.53)

 

That’s right, negative tax. In Ontario, in the two lowest tax brackets, the tax rate on eligible dividends is actually negative.

As good as this sounds however, this negative tax rate is only beneficial when there is other income. Because the Dividend Tax Credit is a non-refundable tax credit, there can’t be negative tax, if tax is negative then you just lose some or all of the Dividend Tax Credit. If there is no other income then the final tax would be zero.

However, there is an opportunity to trigger extra income to use up these non-refundable tax credits if they’re not being used. This can help lower income tax in retirement.

Note: Non-eligible dividends are taxed similarly but the gross-up is only 15%, the Federal dividend tax credit is only 9.0301%, and the dividend tax credit is only 3.2863% in Ontario for 2019.

 

 

How Eligible Dividends Can Help Lower Income Tax In Retirement

Because eligible dividends in certain provinces have a negative tax rate at lower income levels this can be very beneficial for retirees who want to lower their taxes in retirement. Depending on the province, this negative tax rate could apply to many retirees who have non-registered investments.

In Ontario as an example, a couple could earn up to $97,070‬ in taxable net income before their dividends experience a positive tax rate.

To demonstrate the benefit of eligible dividends in retirement we’ll use an example. We’ll assume a retiree is earning marginal dividend income of $10,000 each year. We’ll assume that their other tax credits, like the basic personal exemption and the age amount, are being used up by CPP and OAS income. Using our example from above…

 

Cash Dividend: $10,000

Grossed Up Amount: $13,800 ($100 x 138%)
Tax Rate: 20.05% (Combined Federal and Ontario)
Tax Before Credit: $2,766.90 ($13,800 x 20.05%)

Dividend Tax Credit Rate: 25.0198% (Combined Federal and Ontario)
Dividend Tax Credit: $3,452.73 ($13,800 x 25.1098%)

Tax After Credit: -$686.83 ‬ ($2,766.90 – $3,453.73)

 

Because of the negative tax rate we can actually trigger some extra income to use up these non-refundable tax credits and still pay zero tax. If we don’t use them they’ll just disappear because these are non-refundable tax credits and they cannot bring tax below zero.

The easiest way to use up these non-refundable tax credits in retirement is to make a strategic RRSP withdrawal, even if it’s not necessary to help with annual living expenses.

A strategic RRSP withdrawal would be taxed at the marginal tax rate of 20.05%. So with a negative tax of -$686.83 this retiree can actually withdraw $3,425.59 from their RRSP without paying any extra tax.

 

Strategic RRSP Withdrawal: -$3,425.59 (-$686.83 / 20.05%)

 

By making a strategic RRSP withdrawal they’ll trigger just enough tax at the marginal tax rate to use up all of the non-refundable tax credits. This retiree will be able to withdraw $3,425.59 from their RRSP tax free!

 

 

How Eligible Dividends Can Hurt High Income Retirees

On the flip side, eligible dividends can hurt higher income retirees who may experience the OAS clawback (officially the OAS Recovery Tax).

This tax is levied when net taxable income is above a certain income threshold for an individual. For 2020 the threshold is $79,054. Once net taxable income crosses this threshold the extra income is subject to the 15% OAS clawback.

For someone earning income just below the OAS clawback threshold the dividend gross up can push them over the threshold and cause extra clawbacks. This income could be from pension, CPP, OAS, minimum RRIF/LIF withdrawals etc.

For example, for a retiree earning $79,000 per year plus an extra $10,000 in eligible dividends, the gross up will add $3,800 to their net taxable income due to the gross up. Even though the $3,800 is just the grossed up amount, and isn’t actually cash received by the retiree, it will still be subject to the OAS clawback of 15%.

Ideally these eligible dividend producing investments would be held in a tax advantaged account like a TFSA. Inside the TFSA the dividends would not trigger the gross up. The $10,000 in dividends could be withdrawn from the TFSA and there would be no OAS clawback.

 

 

The Advantage Of How Dividends Are Taxed

For most people there is a significant tax advantage when investing in Canadian companies producing eligible dividends.

The way these eligible dividends are taxed can help offset other income from CPP, OAS, pensions and RRSP withdrawals. With a bit of tax planning this advantage could add thousands in after-tax income for a retiree.

This won’t apply to every person. This is only an advantage for those who have already maximized their tax advantaged accounts like TFSA and RRSP. Taking advantage of the dividend tax credit will require a portfolio of non-registered investments. It will also require a more complex asset allocation, with certain assets being held in certain accounts (non-reg versus TFSA versus RRSP).

This type of complex asset allocation isn’t possible when investing with a robo-advisor or an ‘all-in-one’ ETF. Plus, this extra complexity can make it less attractive for anyone who isn’t comfortable doing the extra work for their own individual investments.

Still, the way dividends are taxed can make them very attractive for retirees who want to maximize their after-tax income and minimize taxes in retirement. This type of tax planning should definitely be a consideration for any retiree (or future retiree) with a sizable non-registered portfolio.

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Owen Winkelmolen

Financial planner, personal finance geek and founder of PlanEasy.

New blog posts weekly!

Tax planning, benefit optimization, budgeting, family planning, retirement planning and more...

New blog posts weekly!

Tax planning, benefit optimization, budgeting, family planning, retirement planning and more...

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