The high cost of high dividends

Investors who use high-dividend strategies may well be better off sheltering their equities in an RRSP due to the dividend tax.

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In our recent white paper, Asset Location for Taxable Investors, Justin Bender and I argue that most investors are better off keeping their bonds in an RRSP, while equities should be held in a taxable account (assuming, of course, that all registered accounts have been maxed out). At the end of the paper, however, we noted one exception: investors who use high-dividend strategies may well be better off sheltering their equities in an RRSP.

Stocks can be relatively tax-efficient because much of their growth comes from capital gains, which are taxed at just half the rate of regular income and can be deferred indefinitely. Canadian dividends also receive a generous dividend tax credit that benefits low-income investors in particular: a retiree in Ontario whose only other source of income is the Canada Pension Plan and Old Age Security might be able to collect more than $20,000 a year in eligible Canadian dividends and pay no tax.

Getting paid taxed to wait

But if you’re still working and earning a good income, a dividend strategy may come at a high cost, especially if your taxable portfolio includes foreign equity ETFs. That’s because foreign dividends are fully taxable as income: double the rate of capital gains.

Consider two foreign equity ETFs: one appreciates in price by 3% and pays a 4% dividend, while the other grows by 5% but pays a 2% dividend. In an RRSP, the total return on both funds is an identical 7%. But in a non-registered account, the after-tax return would be significantly lower for the high-dividend fund.

Here’s a simple example for an Ontario investor in the highest tax bracket, where capital gains are taxed at 23.20%, Canadian dividends at 29.52%, and foreign income at 46.41%:

Amount 3% cap gain 4% dividend Total tax
Canadian $10,000 $69.60 $118.08 $187.68
Foreign $10,000 $69.60 $185.64 $255.24
 .
Amount 5% cap gain 2% dividend Total tax
Canadian $10,000 $116.00 $59.04 $175.04
Foreign $10,000 $116.00 $92.82 $208.82
.

In this example, the difference is small for Canadian stocks, but for foreign equities the high-dividend strategy results in a tax bill 18% higher. And this assumes the capital gain is realized at the end of the year. In reality, an investor in the accumulation stage can defer that gain indefinitely by not selling ETF shares, and by taking advantage of tax-loss harvesting opportunities as they arise. If those capital gains can be deferred until retirement and realized at a lower rate, the low-dividend strategy looks even more attractive.

When less is more

This is something to keep in mind when considering dividend-oriented ETFs such as the RBC Quant U.S. Dividend Leaders (RUD) and the RBC Quant EAFE Dividend Leaders (RID), which I discussed in my last post. These ETFs boast yields of 3.8% and 4.8% respectively, which look attractive. But even if they modestly outperform the broad-market indexes on a pre-tax basis, taxable investors might end up with less, because those big dividends will be cut in half by the CRA.

If you hold foreign equities in a taxable account and you’re inclined to invest in dividend payers, consider ETFs that focus on dividend growth rather than high yield. The Vanguard Dividend Appreciation ETF (VIG), for example, holds companies with a record of raising its payouts, but its current yield is barely over 2%, only slightly above that of the overall US market.

You should also think carefully before considering income-oriented foreign investments such as global REITs. The SPDR Dow Jones Global Real Estate ETF (RWO) currently throws off more than 3.5% in fully taxable income and should probably be held in an RRSP or not all.

There’s also a lesson here for investors who have recently maxed out their RRSPs and are now forced to hold some assets in taxable accounts. The first asset class to go in the non-registered account should be Canadian equities, which are the most lightly taxed. Next on the list is US equities, which currently have quite low yields. International equities, with their relatively high payouts, should be sheltered from taxes as long as possible.

One comment on “The high cost of high dividends

  1. Dividend stocks should go in Tax Free Savings Accounts until it is maxed out. This will ensure a constant flow of untaxable income which will not decrease any other income related pensions.

    Obviously, the TFSA maximum amount is limited, which is why it should be maxed as soon as possible and use a DRIP to let it grow as much as possible until retirement.

    Actually, this strategy should be used by anyone who is contributing for less than 5k$ to their RRSP each year.

    Reply

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