The dividend investor’s dilemma: Should you use a TFSA, RRSP, RRIF or taxable account? (2024)

A logistical question for the well-stocked dividend investor: What kind of account are you using for the shares you own?

Now’s an ideal time to address the ins and outs of holding dividend stocks in taxable accounts, in tax-free savings accounts and in registered retirement savings plans and registered retirement income funds. Interest rates on bonds and term deposits are dismayingly thin and not expected to rise much in 2021.

Yields on dividend stocks are nearly a lottery win by comparison and thus certain to hold the attention of investors. Picking the right account is about optimizing your results to reduce tax on your dividend income.

Our guide to choosing the right account for dividend investing is Wilmot George, a certified financial planner (CFP) and vice-president of tax, retirement and estate planning at CI Investments Inc. A quick introductory heads-up: Mr. George is not militant about parking dividend stocks in one type of account versus another. Diversified portfolios are the top priority.

“I look at what my primary objectives are, and then I try to make my situation tax-efficient,” he said. “I don’t let tax drive my decisions.”

Taxable accounts

We’ll refer throughout to eligible dividends paid by Canadian corporations. In other words, the dividends typically paid by publicly traded companies. Mr. George said dividends are a good choice for a taxable account because they benefit from the dividend tax credit, which limits the tax hit in comparison with bond interest and other types of regular income.

“A quick glance at a tax table tells the story,” he said. “At the top tax rate for 2020 in Ontario, you’re taxed at 53.5 per cent for interest income, 39.3 per cent for dividends and 26.8 per cent for capital gains.”

One disadvantage of dividend stocks in a taxable account concerns the calculation of the gross-up, which is part of the process of reporting dividend income for tax purposes. For the 2020 tax year the gross up is 38 per cent, which means if you had $100 in dividend income last year, you must report $138 of taxable income.

For seniors, the grossed-up amount becomes an issue if it pushes your income above the threshold at which a clawback of Old Age Security benefits begins – $79,054 for the 2020 tax year.

U.S. and foreign dividends are considered as regular income in a taxable account – the dividend tax credit does not apply. Within your investment account, expect a foreign withholding tax to be applied to dividends paid by U.S. and international companies. You can normally claim a 15-per-cent foreign tax credit to offset this withholding tax. That’s a federal tax credit – a provincial credit may also be available.

A modest disadvantage of dividends in a taxable account is that you have no ability to defer taxes to future years. One way around this would be to invest in a total-return exchange-traded fund from Horizons ETFs – the Horizons Canadian High Dividend Index ETF (HXH).

Using financial instruments called derivatives, HXH units rise and fall in price by a total return amount that blends share price changes and dividends. No cash is paid, so there are no dividends to be taxed each year. If your fund holdings rise in price, you’ll pay capital gains tax in the year you sell.

TFSAs

If there’s an ideal home for Canadian dividend stocks, it’s this type of account. “TFSAs are a dream,” Mr. George said. “You’re not dealing with any kind of Canadian taxation at all.”

Unfortunately, the same cannot be said of dividends from U.S. and international stocks. Remember the withholding taxes mentioned just above? In a TFSA, you can’t recover them using the foreign tax credit.

For Canadian investors, U.S. withholding taxes work out to a 15-per-cent reduction on your dividend payments. According to BlackRock Canada, the weighted average foreign withholding tax rate on international stocks (outside North America) is 12 per cent.

A quick note about withdrawing dividend income from a TFSA – you can recontribute this amount to your TFSA at later date. To avoid TFSA overcontribution penalties, make this repayment in the calendar year after your withdrawal.

RRSPs and RRIFs

One advantage of holding Canadian dividend stocks in a registered retirement account is the ability to defer taxation, Mr. George said. In RRSPs and RRIFs, you pay tax only when you withdraw from the plan. Unfortunately, these withdrawals are treated as regular income and not eligible for the dividend tax credit.

“In an RRSP or a RRIF, you’re trading off tax-sheltering against full taxation on the way out,” Mr. George said.

Dividends paid by U.S. stocks make some sense in registered retirement accounts. Through a Canada-U.S. tax treaty, the 15-per-cent withholding tax does not apply to dividends paid into both RRSPs and RRIFs. Expect the usual withholding taxes to be applied to dividends paid by international stocks held in a registered retirement account, with no recourse to the foreign tax credit.

Final thoughts

Mr. George said there’s a general rule that less tax-efficient investments should be held in registered accounts, and more tax-efficient investments in taxable accounts. Where dividend income lies on the efficiency scale depends a lot on your income level.

If your taxable income is $40,000, the marginal tax rate for 2020 on eligible dividends is zero in several provinces and territories. At a taxable income of $75,000, dividends in most provinces are taxed at a lower rate than capital gains. At $125,000, there’s a split where both types of income are about equally tax-friendly; at $200,000, capital gains have the lower tax burden almost everywhere. To compare provinces, try the Ernst & Young personal tax calculator (bit.ly/EYpersonaltaxcalculator).

Note that these calculations are based on the current 50-per-cent capital gains inclusion rate (just half your gain is taxed). “We don’t know where the inclusion rate might go in the next federal budget,” Mr. George said. “If the inclusion rate is adjusted, then that changes the discussion.”

Stay informed about your money. We have a newsletter from personal finance columnist Rob Carrick. Sign up today.