Trying to maximize your after-tax retirement income is a complicated business. Cheerleaders for dividend investing are convinced that the dividend tax credit makes it a no-brainer that a dividend strategy is best to minimize taxes. However, as we’ll see, there are good strategies that use the 50% capital gains exemption as well.
Let’s look at two investors in the same situation but using different investment strategies. Dean, the dividend investor, and Carla, the capital gain investor, are both 58 years old, single, and living in Ontario. (No, there will be no romance in this story.) They both have a $500,000 RRSP and $1,232,000 in a non-registered account. (I’ll explain this cooked-up number.)
Dean owns dividend stocks that we’ll assume earn a 2% capital gain and 4% dividend each year. Dean’s dividend income is 4% of $1,232,000, or $49,280. This just happens to be the maximum he can earn and pay no taxes other than the $600 health premium.
Carla earns the same total return of 6% each year, but she owns the exchange-traded fund HXT so that all her returns are capital gains. Obviously, her return will not be exactly 6% each year, but as we’ll see, her strategy is flexible. Carla’s plan is to withdraw the same annual income as Dean ($49,280), but she is going to split it between her RRSP and her non-registered account so that her total taxable income is $14,700. This is the level of income where she pays about $600 in taxes, the same as Dean.
Carla’s withdrawals will be spread evenly through the year. Let’s assume that the average capital gain on her withdrawn capital during the first year is 3%. If Carla withdraws $35,091 from her non-registered account, this will be a $34,068 return of capital and a $1022 capital gain of which $511 is taxable. If she withdraws $14,189 from her RRSP, she will exactly hit her income target of $49,280 and her taxable income target of $14,700.
In the second year, Carla will have more deferred capital gains and won’t be able to withdraw quite as much from her RRSP. Her RRSP withdrawals continue to decrease in future years as her non-registered account capital gains build up.
I simulated 7 years of Dean and Carla’s strategies assuming 2% inflation and assuming the income tax thresholds rise with inflation. After these 7 years, both Dean and Carla have paid the same amount of income tax (almost nothing) and have the same total assets. However, their split between accounts is different. Here are their situations at age 65 (rounded to the nearest thousand):
Non-registered account: $1,415,000 (unrealized capital gain of $183,000)
Non-registered account: $1,515,000 (unrealized capital gain of $514,000)
There isn’t an obvious winner here. Carla has managed to use up some of her RRSP tax-free, but Dean has a smaller unrealized capital gain.
Observe that Dean and Carla are now somewhat locked into their respective strategies because of the unrealized capital gains. Any change of strategy requires some selling that would lead to significant capital gains taxes.
As Dean starts to draw OAS and possibly CPP, his tax situation changes; he will be paying income taxes on his dividends. Carla will pay some taxes as well but she has more flexibility in how much capital gain she chooses to realize.
At the end of the year they turn 71, things change significantly again as they will both have to make mandatory RRIF withdrawals. Dean’s taxable income will rise to the point where he will pay significant taxes including a substantial OAS clawback. Carla’s taxes will rise too, but she will once again have more flexibility in how much capital gains she will realize.
To make a complete comparison of Dean and Carla’s strategies, we’d have to make assumptions about CPP payments, desired income levels later in life, and how much of an inheritance they’d like to leave. I don’t see much point in doing this, mainly because the strategies so far have both of them living on less in their 60s than in their 70s, 80s, and beyond. It’s more realistic to devise strategies that aim for constant inflation-adjusted income with adjustments if portfolio returns disappoint.
I’ve made a few attempts to devise tax-smart strategies based on targeting a constant after-tax real income for life (with adjustments if portfolio returns disappoint). I also included a safer risk level than Dean and Carla’s 100% stock allocation, and took into account TFSAs.
Each time I work out the final result in an analysis that is more complex than the scenarios above, I find that capital gains strategies give slightly higher income than dividend strategies. While I’ve tried to optimize each strategy, I can’t guarantee that I’ve made the best possible choices to minimize taxes.
So, I can’t say with any certainty whether dividend investing is better or worse for taxation, and it may depend on the specifics of account sizes and other factors. What I can say with some confidence is that those who focus solely on the dividend tax credit are missing the big picture.