Many investors love Canadian dividends because they come with a tax break called the Dividend Tax Credit (DTC). Others look a little deeper and say that the DTC just prevents double taxation because the companies paying dividends already had to pay tax on their profits. They conclude that dividend income is no better than interest income, at least from a tax perspective. However, comparing the DTC to capital gains taxes gets more complex. Dividend Taxation in Canada The DTC is intended to prevent Canadian company profits paid to Canadian shareholders from getting taxed twice. Here’s an example to illustrate the idea: Suppose a company earns one dollar in profit per share, pays 27 cents in income taxes, and pays the remaining 73 cents in dividends to each shareholder. Canadian shareholders actually declare the full dollar as income (called the dividend gross-up), but they get to deduct the 27 cents from the taxes they owe. The idea is that the total tax paid by the company ...

Reader ML asks the following good question (edited for length): I am relatively new to investing for dividends. Currently my strategy is to invest in high quality stocks and hold them for a long time. You are one of the bloggers who switched from buying individual stocks to buying ETFs. I get the strategy of ETFs in that it’s hard to beat the market with individual stocks. My question: Over years the dividend you receive from an individual stock continues to grow. If ETFs switch over their portfolio would they not miss out on this increase in dividends, year over year? It seems to me that the dividends stay pretty steady in the ETFs. Is that not a big chunk of money to miss out on? The short answer is that ETF dividends do grow. The dividends that low-cost index ETFs pay are mainly the dividends collected from all the individual stocks held within the ETF. There is a small deduction for the costs of operating the ETF and possibly a small increase from securities lending,...

Common advice to make up for high bank fees is to buy bank stocks to get your money back in dividends. We could extend this to the big telecommunications companies as well. I decided to look at how I stand in collecting dividends from these companies vs. what I pay for their products. On the dividend side, it’s not a good idea for your portfolio to be too concentrated. I own Canadian stocks through Vanguard’s Canada All Cap Index ETF (ticker: VCN). The part of VCN’s dividends that come from the six big banks plus Bell, Rogers, Telus, and Shaw amount to about 34 cents per share each year. So, suppose you add up what you pay to these businesses and it comes to $1000 per year. As I write this, you’d have to own $90,800 worth of VCN to collect $1000 per year in dividends. Of course, these businesses don’t pay all of their earnings out in dividends, so you could own a little less VCN than this to have the total profits cover your costs. You could also argue that these businesse...

The strong preference many investors have for dividends over capital gains is known among economists as the “dividend puzzle.” Meir Statman offers a solution to this puzzle in his book Finance for Normal People . Statman says that many investors incorrectly “frame the capital of a stock as a fruit tree and dividends as its fruit. In that frame, collecting dividends and spending them does not diminish the capital of the stock any more than picking fruits off a tree and consuming them diminishes its size.” “Rational investors know the correct frame for dividends and capital. They know that $1,000 in ‘homemade’ dividends from the sale of shares is identical in substance to $1,000 from a cashed dividend check, even if different in form, and they care about their total wealth, not its form.” Because the “price of shares of a company declines when a company pays dividends,” “payments of dividends do not affect the total wealth of investors.” All that said, dividends do offer some a...

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 retu...

There are persistent myths about the tax-inefficiency of RRSPs. Here I debunk these myths using pictures. Myth 1: It is more tax-efficient to earn capital gains in a non-registered account than it is to earn them in an RRSP. A typical justification for this belief is that in a non-registered account only half of the capital gains are taxed, but all of an RRSP withdrawal gets taxed. To explain why this is a myth, let’s enlist the help of a hypothetical investor Ami. Five years ago Ami bought a house on her own and was somewhat house-poor until a promotion and raise two years ago. Since then she has managed to build $11,000 in a savings account without adding any debt beyond her mortgage. Ami plans to use $5000 of her savings toward a used car this summer, but she wants to invest the remaining $6000 for the long term. She is trying to choose among an RRSP, a TFSA, and a non-registered account. Within the account, Ami intends to invest with a goal of earning capital gains. ...

Frugal Trader at Million Dollar Journey wrote a thoughtful post titled 5 Advantages of the Dividend Investing Strategy that caught my attention. He believes that both index investing and dividend investing are good strategies. I’m not sure if he intended his 5 advantages of dividend investing to be advantages when compared to index investing, but I’ll take them this way below. Let’s examine each of these 5 advantages: 1. Produces a Passive Income Stream for Life, and with Raises! Dividend stocks certainly produce passive income that tends to rise over time. However, indexing does the same thing. Dividend stocks produce bigger dividends, but indexes tend to produce bigger capital gains. So, I’d say that this advantage applies equally to both dividend investing and index investing. 2. Encourages Buying and Holding for the Long Term I suspect that this is where dividend investing has an edge over index investing, at least for some investors. No matter how you invest, it’s...

One of the justifications that dividend investors use to justify their belief that they will beat market indexes is the fact that dividend income is more stable than capital gains. Dividend Growth Investor recently explained this line of argument . Dividends do tend to be more stable than capital gains, but this doesn’t mean that dividend investors will beat the market over the long run. Dividend Growth Investor says that “Investors who sell stocks to fund their retirement face the risk of selling off stocks at low prices during bear markets, which could result in asset depletion.” The implication here is that this is not a problem if you own dividend-paying companies. However, the reason why dividends are more stable is that companies do what they can to avoid cutting dividends. Even when it is painful to pay dividends, companies tend to pay them anyway. Even if the money is better reinvested in the business, or better used for an acquisition, or the company is forced to incr...

Rob Carrick points to the RBC Canadian Dividend Fund as an example that “shows why we need to reform the way investors pay for funds and advice.” He makes a number of excellent points about the problem of hiding the cost of advice in mutual fund MERs in the form of trailing commissions. However, I take issue with his claim that because this fund has beaten the S&P/TSX composite index over the past 5 years it “has been such a consistently good money maker.” The Canadian S&P composite index is not the right index for judging the RBC Canadian Dividend Fund. A more appropriate index would be the Dow Jones Canada Select Dividend Index. The iShares ETF based on this index, XDV, beat the RBC Canadian Dividend Fund by 1.1% per year for the past 5 years, which is very close to the difference in their MERs. Another possible index for comparison is the S&P/TSX Canadian Dividend Aristocrats Index. The iShares ETF based on this index, CDZ, beat the RBC Canadian Dividend Fund ...

To buck the trend in most articles titled with a question I’ll actually answer it: no, a dollar of dividends is worth the same as a dollar of capital gains. However, that didn’t stop a commenter, Rob, on a Canadian Couch Potato post from arguing differently. Please note that the Canadian Couch Potato himself was on the correct side of the math on this question, although he had the good sense to spend less time arguing with Rob. Rob’s argument ran as follows. If you had invested $100 in the UK stock market in 1945, it would have grown to $7401 by 2011 if you lived the good life and spent all the dividends. However, if you had reinvested the dividends, you would have $131,469 by now! The return in this case is 18 times higher than the returns due to capital gains alone. So, this must mean that the dividends must be worth 17 times more than the capital gains. We could take this a step further and observe that the average compound return in the UK stock market due to capital gai...

Dividend investors and indexers often disagree strongly on the relative merits of their investing strategies. Recently, the Dividend Growth Investor argued that homemade dividends produced by selling some stock are not as good as real dividends . However, we can easily show that the core of the disagreement comes down to whether or not dividend stocks have an expectation of higher total returns. For the purposes of this discussion, let’s compare an indexed portfolio of stocks that pay a 2% dividend to a dividend stock portfolio that pays an average of 4% dividends, both in tax-advantaged accounts. For the investor who wishes to live on 4% of his portfolio each year, his choices are to go with the indexed portfolio and sell 2% 1 of his shares each year, or go with the dividend portfolio and live off the 4% dividend. Dividend Growth Investor argues that “when someone sells a portion of their portfolio, they end up with less [sic] shares.” However, if the two portfolios get the s...

The dividend tax credit (DTC) has been doing a progressively worse job of compensating for the dividend gross-up in recent years. This has given rise to “phantom income” for dividend investors. The first time I filed my taxes in a year where I received a dividend in a taxable account, I was surprised to find that I had to declare more income than I actually received. This is called the dividend “gross-up”. Fortunately, I also got a deduction from the taxes I owed, called the dividend tax credit (DTC). The idea behind this tax treatment is to coordinate the taxes you pay and the taxes the company distributing the dividends pays. Initially, the company earns some profits, but must pay taxes on these profits. Then the company can pay dividends out of the lower after-tax profit amount. Tax laws for individuals are designed to give you credit for the taxes the company paid. The idea is that you declare the larger amount (which is more than you actually received in dividends) as i...

In the spirit of My Own Advisor’s post The Top 5 Things You Need to Know about Dividend Paying Stocks , I decided to sing the merits of selling 5% of your stocks each year.  I don't want to pick on My Own Advisor because he's a good guy and many blogs say similar things, but I had to pick some blog to have some fun with. 1. Selling 5% of your stocks each year provides an immediate return. Even if your stocks subsequently go down in value, you get to keep the cash from selling 5% of your stocks each year. 2. Safety buffer against the worst case scenario. If the worst happens and the businesses you own go bankrupt, you get to keep the cash from 5% sales in all previous years. 3. The value of that 5% increases over time. As long as your business is successful and produces more than a 5% yearly increase in share value, each year’s sale will be worth more than it was the previous year. 4. Many businesses have a long history of rising share values. Several Canadian ba...

A very popular method of investing is to build a portfolio of individual stocks with a solid history of dividend payments. Dividend investors tend to believe that this approach will beat index investing, and index investors believe that dividend investors have sub-optimal portfolios. Although dividend investing tends to be quite passive in the sense that it involves infrequent trading, it is at least a little bit active in the sense that dividend investors choose individual stocks. Any time you choose an active investing strategy, it makes sense to know how much your strategy is likely to underperform the market averages in the event that your strategy is little better than random. So, if we begin with the premise that index investors are right and that dividend investors are likely to underperform, how much lower are their returns expected to be? To answer this question, I dug up an old paper by Meir Statman: How Many Stocks Make a Diversified Portfolio? In it he reprints a t...

Dividend investing is very popular. Many investors like to have their long-term savings in a collection of dividend-paying stocks. There can be good reasons for preferring dividend-paying stocks over other stocks, but I suspect that the main benefits are emotional. For investors in the lowest tax brackets, dividends are taxed less than capital gains. This is one good reason to prefer dividends over capital gains. However, most of the dividend investors I know are in a high enough tax bracket that they would be better off with capital gains. Some investors believe that dividend-paying stocks pay a larger total return (dividend plus capital gains) than non-dividend-paying stocks. All evidence I’ve seen says that this isn’t true. Some investors believe that long-time consistent dividend-paying companies are less risky than other stocks. I have no opinion one way or the other on whether this is true, but I don’t think this is the dominant reason why some investors prefer divide...

At the suggestion of the moneygardener, I’m writing about the method I used to pay my kids an allowance with stock dividends. This method of paying allowances was also suggested in the book The Lazy Investor (see review here ). Back in the year 2000, I decided to stop giving my kids an allowance out of my pocket. I bought 100 shares of the Bank of Montreal for each of them. Initially it paid them $50 every 3 months, a modest allowance. A nice side effect of this is that instead of having to lecture them about the value of stock ownership, I actually had them coming to me with questions about where the money was coming from, and whether the dividend would increase, and so on. Anything that reduces the number of speeches I have to give to kids who aren’t interested in listening is a good thing. My kids were always happy to see the account statement when the dividends came in, particularly if the dividend had increased. Fortunately, the Bank of Montreal increased the dividend ...

Derek Foster who claims to be Canada’s youngest retiree wrote an interesting book called The Lazy Investor . Before I read the book, I thought the “lazy” part referred to the effort required to handle investments, but it actually refers to being lazy by quitting your job once your investments produce enough income. What sets this book apart from most other investment books is that he recommends specific investments and gives detailed instructions on how to open accounts and acquire shares as cheaply as possible. I tend to agree with most of his general advice: minimize fees, buy stocks rather than bonds, and minimize personal spending in areas that aren’t improving your life. I don’t think it’s necessary to focus exclusively on dividend-paying stocks, but following Foster’s advice would be a big improvement over how the average person invests. The book gives detailed advice on how to get started with very small amounts of money to invest without wasting too much of it on fees b...

It seems to be conventional wisdom that once you start drawing from retirement accounts, your investments should be shifted into income generating assets such as bonds and dividend-paying equities. This makes little sense to me. Let’s consider an example. Suppose that Sam starts retirement with a million dollars in a tax-sheltered account. He invests in dividend-paying stocks and in the first year he makes $40,000 in dividends plus $60,000 in capital gains. He withdraws the cash dividends to live on and leaves the capital gains in the account. Another new retiree, Linda, invests her million dollars in non-dividend paying equities and makes $100,000 in capital gains in her first year of retirement. She sells $40,000 worth of stock to generate cash to live on. What’s the difference between these two cases? Not much. What matters are the returns you get and the risk you take to get these returns. In tax-sheltered accounts, the difference between capital gains and dividends isn’t i...

A rogue trader working for a bank has managed to lose a record $7 billion making unauthorized trades. The trader, Jérôme Kerviel, worked at the bank Société Générale in France. He lost the money trading in the European stock index futures market. Stock index futures are essentially side bets between two parties on whether the stock market will go up or down. This rogue trader made about $40 billion in bets that the stock market would go up, and as we have seen over the last week, those bets didn’t work out very well. When the bank discovered the huge bets, they sold them off quickly and ultimately lost $7 billion in the process. There have been many stories about rogue traders over the years. One thing all the stories have in common is huge losses. Don’t these rogue traders ever get lucky and make money? My guess is that many of them do make money, at least for a while. What would bank management do if they discovered a rogue trader who risked billions, but had made a bill...

Why are there so many different dates associated with dividends? Most companies that pay dividends do so every 3 months on a fixed schedule. They don’t have to do it this way, but shareholders like predictability, and companies want to keep their shareholders happy. You might think that the only important date is when you get your dividend money, but you would do well to understand a few more dates, the most important one being the ex-dividend date. Declaration Date . Just because a company has paid its dividend every 3 months for years, and they are highly motivated to keep the shareholders happy by continuing to pay dividends, there are no guarantees. On the declaration date, the company announces whether it will pay a dividend and whether there will be any change to the dividend amount. Ex-Dividend Date . When buying or selling a stock around the time that the company will be paying a dividend, you may wonder who will get the dividend, the old owner or the new owner. The ex-dividend...