Tax minimization is one of the most important pillars of wealth management. The more you pay in taxes, the less money you have to spend and save. As a result much ink is spilled and many dollars spent in the effort to pay less tax. But when trying to optimize one part of the equation, it can be easy to miss the forest for the trees.
The ultimate goal of wealth management is to maximize after-tax wealth. To use an obvious example, in the quest for tax minimization, no one would pay an accountant $15,000 to execute a planning strategy which would save them $10,000 – you would indeed pay less tax, but you’d rather have more money! This type of myopic thinking can crop up in other ways, too. Thinking about the dividend tax credit is one such way.
The dividend tax credit was built into the Canadian income tax system as a way to prevent “double taxation”. When corporations pay a dividend to give cash to their shareholders, the corporation has already paid tax at the corporate tax rate on that cash. Since investors must pay tax on dividends received, that would result in the same income being taxed twice. The situation is remedied by issuance of a tax credit to the shareholders, which reduces the tax the investors must pay. When originally instituted, the tax credit worked exactly as planned. Over the years, however, in the search for more tax revenue, the value of the tax credit has been diminished significantly. It is no longer as great a benefit as it once was, and in truth, double taxation has crept back into our tax system.
While the tax credit means that dividends will be taxed more lightly than regular income from salary or interest regardless of overall income level, the tax credit is more beneficial at lower income levels. Below is a chart showing the benefits of the tax credit for investors at three levels of non-dividend income: $40,000, $150,000, and $300,000. Each of these investors receives the same $40,000 of eligible dividend income per year – perhaps from a $1,000,000 investment portfolio of Canadian stocks, with a 4% dividend yield.
As you can see, the tax savings compared to regular income declines as income climbs. At the highest tax rate, a 4% before-tax dividend becomes a 2.4% after-tax yield. Were this yield fully taxable (as interest income or employment income), the after-tax amount would instead be just under 2%.
An improvement in real, after-tax returns of about half of one percentage point is nothing to scoff at and should be pursued and utilized in the right circumstances. However, in the grand scheme, this benefit is dwarfed by other factors. On a 50% Canadian, 50% US stock portfolio, a shift in the CAD-USD exchange rate by 2 cents in either direction would have a larger impact on returns than the tax credit. (Indeed, as David Baskin argues, a shift of this magnitude should be considered fairly tame.) And, crucially, by focusing on the small benefits of the dividend tax credit, investors can miss some of the best investing opportunities; Barry Schwartz makes the case for US stock investment here.
Historically, the TSX index has had a yield of about 3.2%. This represents about one-third of the index’s total return. While investors should always plan and utilize all tools at their disposal, time and energy can perhaps be better spent chasing a larger slice of the pie. The dividend tax credit is valuable particularly for low-income investors living off their portfolios. At higher income levels, though, constructing a diversified, intelligent portfolio is far more important in the effort to maximize after-tax wealth.