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Can you explain why eligible dividends are “grossed-up” by 38 per cent and taxed at one’s marginal rate before the dividend tax credit (DTC) is deducted? Why not just apply a lower tax rate to the actual dividend and achieve the same thing? This has always puzzled me.

The reason dividends are grossed up is to approximate the amount of pretax profit the company would theoretically have to earn in order to pay you the dividend. For example, a dividend of $100 is assumed to have been paid out of a company’s pretax profit of $138, with the remaining $38 going to corporate income tax. The DTC essentially gives you “credit” for roughly the amount of tax the company already paid.

Here’s a quick example to illustrate. Say you live in Ontario, where the combined federal and provincial DTC is about 25.02 per cent of the grossed-up dividend. If you make $80,000 and have a marginal tax rate of 31.48 per cent for regular income, on an actual dividend of $100 you would pay tax of $43.44 (31.48 per cent of the grossed-up dividend of $138) minus a DTC of $34.53 (25.02 per cent of $138), for net tax of $8.91. Your effective tax rate on that $100 dividend would therefore be about 8.9 per cent.

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Now, if you do a similar calculation for an Ontario resident with $100,000 of income and a higher marginal tax rate of 43.41 per cent, the effective tax rate on eligible dividends would be about 25.4 per cent.

Notice that, at the $80,000 income level, the effective tax rate of 8.9 per cent on dividends is less than one-third of the marginal tax rate of 31.48 per cent on regular income, whereas at the $100,000 income level the tax rate of 25.4 per cent on dividends is more than half of the regular marginal tax rate of 43.41 per cent.

In other words, as you move up or down the income scale, the tax rate on dividends is not directly proportional to the marginal tax rate on regular income. That’s why you can’t simply multiply your marginal tax rate on regular income by a fixed number to determine your tax rate on dividends. You have to go through the gross-up and tax credit calculation. It’s also why, when an Ontario resident’s marginal tax rate on regular income falls below about 25 per cent – the DTC rate – the effective tax rate on dividends becomes negative. (For more on the DTC, read my column here. For tables showing marginal tax rates in different provinces, see taxtips.ca.)

If I buy a Canadian dividend exchange-traded fund, do I still get the dividend tax credit (DTC)?

Yes. ETFs pass their income on to unitholders, and the portion of that income that consists of eligible dividends will qualify for the DTC. This is only relevant if you are investing in a non-registered account, of course.

I’m concerned that the dividend gross-up will increase my Old Age Security clawback. Isn’t this a reason to avoid dividend stocks?

No. I had a tax expert crunch the numbers in a previous column. His conclusion was that, even with the OAS clawback, dividend income can still be more advantageous from a tax perspective than interest income. Also keep in mind that many dividend stocks offer yields that are substantially higher than the yields on bonds or guaranteed investment certificates.

Dividend investing sounds wonderful but what happens to dividend income in a recession. Don’t the stocks go down quite significantly as well as their dividends?

If you own stocks, their prices are going to fall at times. Rather than try to avoid this, successful investors learn to roll with it. If you hold well-established companies with growing revenues and earnings, such slumps should be temporary. Yes, companies occasionally cut their dividends – commodity producers, highly indebted businesses and companies facing fundamental threats to their long-term profitability are especially vulnerable. But cuts are rare for banks, utilities, power producers, blue-chip consumer stocks and other conservative dividend payers. During the last recession, many companies continued to raise their dividends.

Do you have any plans to start a U.S. model dividend portfolio similar to your Canadian-focused model Yield Hog Dividend Growth Portfolio?

No. Because there are so many great U.S. dividend stocks, and because U.S. dividend ETFs have very low costs, I prefer to keep things simple and get my U.S. dividend exposure – both personally and in my model dividend portfolio – from the iShares Core Dividend Growth ETF (DGRO). It holds nearly 500 U.S. stocks and has a management expense ratio of just 0.08 per cent. (View my model dividend portfolio here.)

E-mail your questions to jheinzl@globeandmail.com.

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