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.