A nice thing about dividends is that they are taxed at a lower rate then interest and other income.
Most people have heard of this but what most don't know is that depending on your province where you are taxed, its possible for an individual with no other sources of income to earn nearly $50,000 in dividends without paying any tax at all.
How you ask? Two main things, the dividend tax credit and the basic personal amount available to all Canadians.
What is the Dividend Tax credit
When you receive a dividend, the money comes from a corporation's after tax profits. Because the company has already paid some tax, it wouldn't be fair to make a shareholder pay again?
Solution, a gross up on the dividend. On your tax return, you gross up the dividend ( 2012 gross up is 1.38) received basically you are converting it back it pre-tax amount. Next you figure out how much tax you have had to pay on that grossed up amount, based on your marginal rate. Finally, you subtract the dividend tax credit. The end result, is the tax you would actually have to pay on the dividend.
Let's put the dividend tax credit into an example, it might be easier to see how it works instead of just having definition typed out for you. Let's say you live in Ontario and you have been carefully building a portfolio over the years and it is now worth $1.2 million. In this example, you will be receiving $47,888 in dividends which equals to a 4% yield. A very possible setup given the dividend yields in today's environment. Let also assume that you have no other sources of income. You would gross up your dividend of $47,888 (times 1.38) to $66,085 which is what you would report on your income statement.
If anyone that knows just the basics of income tax, they would say, what the? I get $47,888 in dividends and I report $66,085? That is just wrong. But look at the table at the bottom of this post, you will see the how you do not have to pay any tax. The total federal tax of $11,549 is offset by the basic personal tax credit and by the federal dividend tax credit.
Also note, that at income levels below $10,882 in 2012, you are getting two credits working for you, the dividend tax credit and the basic personal credit.
it's the same story for Ontario tax.
Other provinces have the same provincial calculation but they all have the same story, the amounts vary but the same story is there.
If a tax payer claims other credits such as spousal, or child credits. They may be able to earn even more dividend income and still pay no tax.
The above example is for information purposes only and uses 2012 data and is to get you thinking but as always, please consult a tax professional for all your tax questions.
Final Thoughts
We all heard of winning the lottery and living off the interest. Well, not all of us will win the lottery but over the years, the power of dividend investing shows it's true colours, you can make your own lottery and live off the interest (dividends in this case) and pay no tax. Now who wouldn't want that? Think about it.
Federal tax
1st $42,707@15% $6,406
(66,085-42,707)@22% $5,143
Less basic credit 10,822@15% (1,623)
DTC 66,085@15.02% (9926)
Net Federal tax 0
Ontario Tax
1st $39,020 @5% $1,971
(66,085-39,020)@9.15% $2,476
Less basic credit $9,405@5.05% (475)
DTC $66,085@6.4% (4,229)
Net 0
Add Sur Tax 0
Total Ontario Tax 0
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