Some of your dividend stocks are getting hammered. Are you planning to change your strategy?
True, a few stocks in my model Yield Hog Dividend Growth Portfolio (I’m looking at you, Enbridge Inc., Canadian Utilities Ltd. and Pizza Pizza Royalty Corp.) have plunged since the portfolio was launched at the end of September. But over all, the portfolio’s performance has hardly been a disaster: For the eight months through May 31, the total return – including dividends – was negative-0.24 per cent. That’s not a reason to panic. What’s more, most of the stocks are continuing to raise their dividends, which is exactly what I was hoping for when I chose them. (Globe Unlimited subscribers can view the latest portfolio update at tgam.ca/dividendportfolio.)
So, no, I am not planning to change my strategy. Despite the recent weakness in dividend stocks, which has been caused mainly by rising interest rates, I am still committed to dividend-growth investing. With any strategy, there are going to be ups and downs and the correct response during a period of weakness isn’t to abruptly change course but to stick with the program. It also helps to look on the bright side: Because stock prices have fallen, when I reinvest my dividends – which I’ll be doing in the weeks and months ahead – I’ll be getting higher yields.
From a tax perspective, which is better in a non-registered account – return of capital or eligible dividends?
As I’ve written before, you will almost always earn the highest after-tax return by investing in a registered account such as a registered retirement savings plan or tax-free savings account. However, if you have maxed out your RRSP and TFSA, investments that pay dividends or return of capital both have advantages in a non-registered account.
Which is more advantageous depends on factors such as on one’s income level, both now and in the future, and the yield and projected returns of the investments in question.
The main benefit of return of capital (ROC) is that it’s not taxable – at least not immediately. Instead, ROC is subtracted from the adjusted cost base of the investment. This results in a larger capital gain – or smaller capital loss – when the investment is ultimately sold. Deferring tax is an advantage, especially if the investment is sold in a year when one’s income is low. Another advantage of ROC is that capital gains are effectively taxed at half the rate of other income. (Note: ROC does become taxable, as capital gains, once the adjusted cost base of an investment falls to zero.)
Eligible dividends from Canadian companies are are also taxed favourably, thanks to the dividend tax credit. In fact, at very low income levels – less than $46,605 for an individual living in Ontario, for example – the effective tax rate on eligible dividends is negative. The government won’t send you a cheque for the negative tax, but you can use to it to offset other taxes payable.
The marginal tax rate on dividends rises gradually as income increases, but it remains below the effective tax rate on capital gains until income reaches $93,208 (again, that’s for Ontario). Above that income level, dividends are taxed at higher rates than capital gains, which makes dividends less appealing, relatively speaking, for higher income earners. (See taxtips.ca for marginal tax rates on various types of income in different provinces.)
Another consideration is that the actual amount of dividends is “grossed up” by 38 per cent to determine your taxable dividend income (before the dividend tax credit is applied). As such, the gross up could result in a claw-back of income-tested credits and benefits such as Old Age Security.
As you can see, there are a lot of moving parts here. If I had two investments – one that distributes exclusively ROC and one that pays only dividends – and I had to choose which one to leave in my non-registered account, I’d probably pick the one that pays ROC. There would be no tax consequences until the investment is sold, whereas, unless my income is very low, I would have to pay some tax on my dividends every year. For the same reason, an investment that is expected to generate its return exclusively from capital gains would probably be a better choice for a non-registered account than a dividend-paying investment.