The standard advice is to put Canadian stocks in non-registered accounts, and put fixed income investments, such as bonds and GICs, inside RRSPs and TFSAs. Tax rates are lower on the Canadian dividend income and capital gains you get from stocks than they are on the interest income you get from bonds and GICs, so keep your stocks outside your RRSP where taxes matter, and then hold your bonds and GICs inside.

U.S. equities are more complicated. Dividends from U.S. stocks are taxed in Canada at regular rates, just like interest income. But capital gains on U.S. stocks—which you trigger when you sell a stock at a profit—are taxed favorably just like capital gains on Canadian stocks. So it makes sense to hold U.S. stocks that pay little or no dividends inside your non-registered accounts alongside Canadian stocks. On the other hand, U.S. stocks that pay handsome dividends probably fit better in your RRSP.

There is an added U.S. tax wrinkle here: the Internal Revenue Service levies a 15% withholding tax on dividends on U.S. stocks held by foreign investors (these are deducted automatically). If a stock pays a 3% dividend, then, the withholding tax would reduce it to 2.55%.

Fortunately, if you hold U.S. stocks in non-registered accounts, you get a credit for the amount withheld that you can apply against Canadian income taxes, so in most cases that leaves you square—providing your Canadian tax rate is at least 15%.

In the case of RRSPs and other retirement accounts, Canada has a tax treaty with the U.S. that exempts you from the withholding tax. But if you hold U.S. stocks in a TFSA or an RESP, you’re dinged the 15% levy and you can’t get it back. As a result, you’re best off holding U.S. stocks that pay hefty dividends inside your RRSPs, and keeping them outside of your TFSAs and RESPs. Who knew?

Keep in mind that dividend withholding tax amounts and treatments vary among other countries, so don’t count on the advice for U.S. stocks applying to stocks from overseas.

“I kind of understand how the dividend tax thing works, but I don’t really know the details,” admits Clark, who is 62 and semi-retired. “I just know it’s better than other types of income.”

Clark isn’t alone in his confusion. Of all the mysteries on your tax return, few are as daunting as the treatment of Canadian dividends. We know that dividend income gets preferential tax treatment, but we don’t know by how much, or why.

To help you really understand how dividend income saves you money at tax time, we’ve enlisted the help of a couple of tax experts. We asked Camillo Lento, a chartered accountant and lecturer at Lakehead University in Thunder Bay, Ont., to calculate how much tax an investor would pay at three different income levels if he earned $1,000 in Canadian dividend income, compared with the same amount in interest income. We’ve compiled the results in the accompanying table, “How much will you save with the dividend tax credit?” (We crunched the numbers for Ontario specifically, as the benefit in that province falls in middle of the pack.) We also got help from Ross McShane, director of financial planning at McLarty and Co. Wealth Management in Ottawa.

Not surprisingly, the results show that investing in Canadian dividend-payers will save you a bundle. But just how sweet the deal is depends on your income. As with many features of our tax system, the benefits are greatest at moderate income levels, and not as attractive as your income rises.

In what follows, we’ll do our best to explain the calculations and show you how you can get the largest tax benefit possible. Get out your calculators, and we’ll begin. Also, read about how to handle your U.S. dividend stocks.

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The sweet taste of taxes saved

If you earn $25,000 a year, the tax benefit you’ll get from Canadian dividend income is enough to make an accountant drool. You not only pay no tax at all on your $1,000 in dividend income, but get this: you actually reduce your taxes on other income. Although the reduction in other taxes is only about $40, that’s still a rare and wonderful thing, what accountants call a “negative marginal tax rate.” All told, after earning $1,000 in dividend income you’re a full $240 ahead of where you’d be after earning the same amount in interest income. That’s about as sweet as it gets.

At higher income levels, the tax savings on $1,000 in dividends is still very good, but not quite as delectable. When we ran the numbers for people earning a total income of $50,000 and those earning an income of $85,000 for our table, we found that you come out ahead by almost $200 when you earn $1,000 in dividends compared to $1,000 in interest income (assuming that you’re under 65). That’s not as exciting as getting tax money back outright, but your inner accountant will still be pleased.

Unfortunately, there’s a complication if you’re 65 or older and subject to the dreaded Old Age Security (OAS) clawback, which applies to seniors with incomes of $67,700 and above. That’s because dividend income counts for more than regular income in calculating the OAS clawback amount. As a result, a senior earning $85,000 would save only $173 in taxes when he or she earns $1,000 in Canadian dividends, compared to the same amount of interest income. The deal is still sweet for affluent seniors, but it will leave you with a sour aftertaste from the clawback. We’ll come back to this later.

A method behind the madness

Now we’ll reveal the secrets of the dividend tax calculation. It turns out the math is so convoluted for a reason.

The best way to understand how taxes on Canadian dividends are calculated is to take a quick three-step tour. First you take your dividend income and multiply it by 1.41, which is what’s known as the dividend “gross-up.” That means $1,000 in dividends becomes $1,410 in income. (The 1.41 figure is for the 2011 tax year and will change in 2012. The good news is that you don’t actually have to do this on your tax return: the government makes financial institutions gross-up dividends before sending out your T3 and T5 slips.)

Second, you take the grossed-up dividend income and apply your marginal tax rate to figure out your taxes so far. If you live in Ontario and earn $50,000, your marginal tax rate is 31.2%. So that works out to $439 in taxes payable on $1,410 in income.

At this point you’re probably not having much fun, because it feels like you’re set up to pay taxes on the inflated amount. Fortunately, there’s a third step that knocks those nasty taxes back down: you get to apply the dividend tax credit. This is another figure you get from your T3 and T5 slips, and it comes to 22.8% of the grossed-up dividend amount. In this case, that would mean a credit of $322 on your grossed-up $1,410 in income. Now you subtract that credit from the taxes payable, in this case, $439. That leaves you with a final tax bill of just $117. Since the benefit of the tax credit is larger than the impact of the gross-up, you end up ahead.

But why does the tax man make you jump through all these hoops? Why not simply charge a lower rate on dividends from the get-go and make it simpler for everybody?

The reason is that tax authorities have their eye on the big picture. “It’s all about tax integration,” says McShane, the financial planner. Think of it this way: the money you receive as dividends starts off as a company’s earnings, and the company pays corporate taxes on those earnings. After paying those taxes, the company takes a portion of the money that is left and passes it directly to you as a dividend, and you pay tax on it again.

The government recognizes that it’s unfair to tax the same income twice. So they give you a break on dividend taxes to offset the taxes the corporation already paid. As a result, you should pay roughly the same tax as if the income had come straight to you in the first place, without passing through corporate hands.

Now that you know what the tax authorities are trying to do, have another look at the three-step calculation. Step one, where you apply the gross-up, brings your income back to the starting point, as if the corporation had never touched it. Step two applies your marginal tax rate to this income, again as if it had never gone through corporate hands. Then step three applies the dividend tax credit to give you back the taxes the corporation actually paid. In general, if your marginal tax rate is higher than the corporate tax rate, you’ll still pay some tax: roughly the difference between the two rates. If your marginal tax rate is lower than the corporate tax rate, you’ll typically get some money back. However, you won’t ever get a cheque from the Canada Revenue Agency: the dividend tax credit is “non-refundable,” which means it can only be used to offset tax otherwise payable on other income.

Before you count on the dividend tax break too much, you should realize that it has been gradually shrinking. That’s because the federal government has been phasing in reduced corporate income tax rates from 2007 to 2012. Since the dividend taxes you pay are based on the difference between your personal tax rate and the corporate tax rate, this means your share of the taxes paid is getting larger. The consolation prize, as Lento points out, is that (in theory) the reduction in corporate taxes should allow companies to increase their dividends.

The dreaded clawback

For affluent seniors, the real unsavoury morsel is the OAS clawback. Remember our first step in the calculation, which inflates a dollar of dividends to $1.41? Well, it’s that grossed-up income that’s used when determining the clawback. Thanks to this seemingly twisted math, dividends can appear less desirable than interest income in this situation.

As you can see in our table, for the senior with an income of $85,000, an extra $1,000 in interest income reduces OAS by $150, but the same amount of additional dividend income reduces OAS by $212.

The tax authorities use a similar approach to calculate other clawbacks on income-related seniors’ benefits, including the Age Credit, which is shown in the examples laid out in our table. The same principle also works against lower-income seniors who are potentially eligible for the Guaranteed Income Supplement (GIS). The GIS is reduced in proportion to your other income, and it too uses grossed-up dividends when making the calculation.

Most seniors feel a bit cheated when they learn that dividends affect the clawbacks in this way. But remember, when it applies to OAS, you’re still ahead of the game. “Even though they’re giving back some of the OAS, the retiree is still further ahead overall with a dollar of dividends rather than a dollar of interest,” says McShane. So while you may have to scoop out that fly in your ice cream and set it aside, your dividends are still likely to provide a tasty meal.

Should you treat U.S. stocks differently?

By this point you no doubt realize that the tax break on dividends only applies to Canadian stocks, not U.S. stocks. As a result, you need to treat the two differently when fitting them into your portfolio.

The standard advice is to put Canadian stocks in non-registered accounts, and put fixed income investments, such as bonds and GICs, inside RRSPs and TFSAs. Tax rates are lower on the Canadian dividend income and capital gains you get from stocks than they are on the interest income you get from bonds and GICs, so keep your stocks outside your RRSP where taxes matter, and then hold your bonds and GICs inside.

U.S. equities are more complicated. Dividends from U.S. stocks are taxed in Canada at regular rates, just like interest income. But capital gains on U.S. stocks—which you trigger when you sell a stock at a profit—are taxed favorably just like capital gains on Canadian stocks. So it makes sense to hold U.S. stocks that pay little or no dividends inside your non-registered accounts alongside Canadian stocks. On the other hand, U.S. stocks that pay handsome dividends probably fit better in your RRSP.

There is an added U.S. tax wrinkle here: the Internal Revenue Service levies a 15% withholding tax on dividends on U.S. stocks held by foreign investors (these are deducted automatically). If a stock pays a 3% dividend, then, the withholding tax would reduce it to 2.55%.

Fortunately, if you hold U.S. stocks in non-registered accounts, you get a credit for the amount withheld that you can apply against Canadian income taxes, so in most cases that leaves you square—providing your Canadian tax rate is at least 15%.

In the case of RRSPs and other retirement accounts, Canada has a tax treaty with the U.S. that exempts you from the withholding tax. But if you hold U.S. stocks in a TFSA or an RESP, you’re dinged the 15% levy and you can’t get it back. As a result, you’re best off holding U.S. stocks that pay hefty dividends inside your RRSPs, and keeping them outside of your TFSAs and RESPs. Who knew?

Keep in mind that dividend withholding tax amounts and treatments vary among other countries, so don’t count on the advice for U.S. stocks applying to stocks from overseas.

Plan ahead

“Many people never talk about how they see day-to-day life after retirement,” points out D’Aprix. “They talk about the big trips and the money—not about how much time they’re going to spend together and what that time is going to be like.” Her advice: look at a blank calendar and ask yourself how you’re going to fill those days “when every day is a Saturday.” You may be able to ease the transition by working part-time or volunteering.

Communicate

For the Edgeworths, the key to re-establishing harmony involved open communication. “Look, you’re ready to retire, but I’m not,” Marjorie eventually told John. He explained that he was okay with her working , but wondered if she might reduce her hours. “I’m working less now,” Marjorie says. “I respect the fact that he wants to spend time with me, so I have carved out certain times for that.”

Be self-reliant

When one partner is already at home most of the time, it can be hard for their newly retired spouse to plug into his or her existing routine. Recently retired nuclear scientist Dave Whillans had commuted each day from Toronto to Pickering for work while his wife stayed at home. “We led very separate lives,” he says. Now his wife, Gail, continues to attend fitness classes three days a week, while Dave runs. She does coffee with friends while he takes the grandkids biking. While the couple still make time for each other, Dave isn’t totally reliant on his wife to keep him busy. “Integrating into somebody else’s already established life is much harder than just looking after your own,” he says.

Rethink the chores

Many couples experience a renewal of the chore wars after retirement, says D’Aprix. It’s crucial to decide if you will move to a different division of labour. In the Edgeworths’ case, although John didn’t participate in many household tasks while he was working, he has since learned to do some cooking and laundry—which has gone a long way in smoothing out tensions between the couple. “It has taken time, but I’ve seen a big change,” says Marjorie

When it’s time to leave the working world, have your investment portfolio provide a regular income so you can enjoy a comfortable lifestyle for years to come. That means adding a few good dividend stocks to your portfolio to receive regular cash payments. It doesn’t mean there’s no risk involved, but dividend investors can sleep easier knowing that their stocks are relatively stable.

Our annual Retirement 100 list – Fall 2011 offers insight into Canada’s best income stocks, which we’re proud to say beat the markets’ overall returns since it was started in 2007. In fact, if you had invested in our All-Star stocks four years ago and reinvested the dividends, you would be richer by 39.2% right now.

Read about how well MoneySense‘s Retirement 100 top dividend stocks have done and how MoneySense staff compiled the grades of Canada’s largest dividend stocks.

Learn How to Build the Ultimate Income Portfolio so you will have a growing portfolio and steady stream of income. Consider the pros and cons of preferred shares and whether they’re a good buy for you.

How to use the list

Click on the column name to organize the stocks according to any one of the financial ratios and performance figures. To reverse the order, click the column name again.

Research more about the investment by clicking on the stock or trust name. Download the list into a spreadsheet to be used later. For the full explanation on how to use the list, scroll down to the bottom of the list.

View the rankings by category

Company

Price

Dividend Yield

Price/Earnings

Dividend earnings (%)

Debt to equity

Price/Book

Grade

Voluntourism

If you want go on an overseas adventure and help out in a developing country at the same time, consider volunteering your services. In many cases, sponsoring organizations will cover your accommodation and living costs if your skills are in particular demand, says Feaver. That might leave you only paying for airfare. Even if your skills aren’t particularly sought after and you have to cover all the costs yourself, the trip is probably still well worth it. “Across the board, when I talked to volunteers they said they thought they were going somewhere to help,” says Feaver. “But they found out they got more out of it themselves than they could possibly give to a community.”

Hospitality exchanges

A social way to travel abroad inexpensively is to exchange hosted visits with people from overseas. Friendship Force is a worldwide organization of older adults that facilitates group exchanges between local chapters. They have about 20 local clubs in Canada and 350 around the world. The way it works is about 20 to 25 members from one club will visit members of another club for a week, staying in the homes of some members and being shown the sights by others. Then the travelers reciprocate by serving as hosts of another club’s visit. “You basically host them for a week and show them the town,” says Feaver. “It doesn’t have to be elaborate or expensive.”

Hostels for all ages

While you might think you’ve outgrown hostels, they’re not just for callow youth anymore. While you can stay ultra-cheaply in the dorm-like conditions that you expect from hostels, you may also be able to book private rooms with bathrooms at a cost that’s similar to a low-end hotel, says Feaver. And these days you can book online. “Hostels are very much a mixing place of independent travelers,” he says. “It’s much more social than staying at a hotel.”

The secret is looking at retirement travel as fundamentally different from the vacations you took while working. Now time is on your side. You no longer need to turn vacations into short, intense bursts of one week or less. You don’t need to travel at high season because of work or school schedules. With a more relaxed schedule, you can let go of conveniences like expensive hotels and restaurant meals. Now you can travel off-peak, find cheaper long-term accommodation, and prepare most of your own meals.

But don’t take our word for it. We spoke to four couples who are retired (or close to it), and who have learned to enjoy adventurous travel on a budget. You’ll hear how one couple visited Sweden just for the cost of two plane tickets, and how you and your partner can spend two weeks in a villa in Provence for just over $5,000, or a month in Tuscany for less than $10,000. If learning about life in exotic locales is more of a priority, you’ll hear from a couple who enjoyed a packaged vacation to South Asia for $10,000. The truth is you can get a great travel experience on just about any travel budget with a little creativity and flexibility.

Swede surrender

In July, Maureen and Garth Holloway spent a two-week vacation in Sweden, and it only cost them the price of two airline tickets—plus the normal living expenses they would have had at home. Their secret? The retired teachers in their early 60s swapped homes (and cars, computers, even golf clubs) with a Swedish family.

The Holloways took up residence in a four-bedroom townhouse in a suburb of Stockholm, while the Swedish family lived in the Holloways’ 150-year-old four-bedroom heritage house in Cobourg, Ont. Airfare cost the Holloways a combined $2,800. Other than that, “it was no more costly than if we stayed in Cobourg,” says Garth.

The Holloways are veteran travelers who have seen a lot of the world over the last 40 years. They have tried everything from moderately luxurious hotels to travelling around Europe in a Volkswagen camper. They had long wanted to go to Sweden, but they knew the country was expensive. Then they discovered Intervac Canada (www.intervac.ca), part of a global home exchange organization with 30,000 listings in about 50 countries. They met the Swedish family online and arranged the swap. Then they flew to Stockholm on the appointed day, picked up the Swedish family’s car at the airport and drove to their townhouse. “It was so easy. Within half an hour of leaving the airport in Stockholm we were sitting in the backyard drinking the wine they left us and heating up the dinner they had left in the fridge,” says Garth. “Maureen and I looked at each other and said, ‘Why didn’t we do this sooner?’”

The Holloways used the townhouse as a base to take day trips around the southern part of the country. The couple are avid readers of Swedish mystery writer Stieg Larsson, and they followed a self-guided tour of the district in Stockholm where much of Larsson’s Millennium trilogy is set. Maureen says the tour included many of the settings for episodes in the books, right down to the local store where Lisbeth Salander (the fictional “girl with the dragon tattoo”) was supposed to have bought her pizzas. They also enjoyed seeing galleries, museums, and the lush farming landscape of southern Sweden.

The Holloways generally ate modest lunches at local restaurants while on day trips, and later prepared supper back at the townhouse. They shopped for food at local stores and Maureen enjoyed preparing typical Swedish dishes, like meatballs. (She says everyday Swedish cuisine is pretty much what you see in the cafeteria at Ikea.) The couple liked just hanging out at the townhouse, watching a bit of television or listening to music. “You get to experience how people live, not how hotels and the tourism industry presents a place,” says Maureen.

Old Age Security
This federal benefit pays $6,400 a year to long-time residents of Canada starting at age 65. It gets gradually clawed back at an income of $67,700, until it is eliminated at $109,600.

Guaranteed Income Supplement
This federal program for low-income seniors pays up to $8,700 a year for singles, and up to $11,500 for most couples. Roughly 50 cents is clawed back for each dollar of income (not counting OAS). GIS is fully clawed back at $16,200 for singles, and $21,400 for couples.

Pension Income Credit
This is a 15% federal tax credit on up to $2,000 in eligible pension income, which can save up to $300 in taxes for those 65 and older. Eligible income must come from a defined benefit pension from your former employer, a Registered Retirement Income Fund (RRIF), an annuity purchased with funds from an RRSP, and a few other sources. Withdrawals from an RRSP don’t count, so if you don’t have an employer pension, convert some of your RRSP money to a RRIF or annuity when you turn 65 to get the credit.

Age Credit
Once you reach 65, you’re entitled to a 15% federal tax credit on income of $6,537, for total tax savings up to $980. But the credit is gradually clawed back when your income reaches about $33,000, until it is eliminated at $76,500.

RRSP withdrawals
If you take money from an RRSP, you’re subject to a with-holding tax that starts at 10% for a withdrawal up to $5,000, with higher rates on larger amounts. Note this isn’t an additional tax, but rather a prepayment on the taxes you’ll eventually pay when you file your return.

RRIF conversions
Before age 71, you have the option of taking money directly from an RRSP or converting to a RRIF and taking the withdrawals from there. At age 71, you must convert your RRSPs into a RRIF or annuity. RRIFs are subject to mandatory minimum withdrawals every year.

Pension splitting
If you’re 65, up to 50% of pension income (including RRIF withdrawals) can be split with your spouse. This can help couples even out their incomes and save on tax. You might want to convert part of your money to a RRIF after 65 to generate regular income, earn the Pension Income Credit, and help with pension splitting.

Annuities
When you convert your RRSP to an annuity (a type of insurance product that guarantees you a fixed income for life), the payments are taxable, just like withdrawals from a RRIF. However, an annuity can provide a smoother and more predictable flow of income than a RRIF.

If you buy an annuity with non-registered funds, generally only a portion of the payments are taxable.