Did you know that there are two ways you can legally pay no taxes on dividends?
The first one — holding your dividend stocks in a Tax-Free Savings Account (TFSA) — is one you likely already know about.
There’s another one, though, that you probably have never heard of. In this article, I will explore the two ways that you can pay no taxes on dividends, starting with the TFSA method and then moving on to the second, lesser-known method.
The TFSA method
The TFSA method for paying no taxes on dividends is simple. Just hold your dividend stocks in a TFSA. If you don’t have a TFSA, just go to your bank and talk about opening one. Once they open up the account for you, simply deposit some funds in it. Then, purchase whatever stocks you like and have researched thoroughly. If you were 18 or older in 2009, you’d have $95,000 worth of TFSA contribution room right away. Invest $95,000 at a 5% portfolio yield, and you’ll get $4,750 in annual cash back — totally tax free!
Holding dividend stocks in a TFSA can definitely save you money if dividend stocks are all you’re holding. However, if you’re going to be holding bonds along with dividend stocks, bonds should take precedence for being included in the account. The reason is that interest is taxed much more steeply than dividends are. You pay your full marginal tax rate (the tax rate in your highest bracket) on interest. You get to offset a tax credit against your dividends. Because dividends are somewhat taxed-advantaged by default, it makes sense to prioritize putting bonds and Guaranteed Investment Certificates (GICs) in your TFSA.
The dividend tax credit method
Next up, we have the dividend tax credit method. This is a great method to use if your TFSA is already maxed out or if you would prefer to put bonds in your TFSA.
The way this works is pretty simple.
First, pick a stock that has eligible dividends. “Eligible” means it has to be a dividend paid by a Canadian corporation. Fortis (TSX:FTS) is a good example of a stock that pays an eligible dividend. This stock has a 4.42% dividend yield, meaning that it generates a lot of cash income with comparatively little invested. So, it pays to claim the dividend tax credit on a stock like Fortis.
Second, you need to calculate your dividend tax credit. This is pretty simple. If you have $95,000 invested in Fortis, your pre-tax dividends come to $4,200 per year. You gross that amount up by multiplying it by 1.38, which gets you to $5,796. Then, you multiply $5,796 by 15% to get a $869 tax credit. Next, subtract that amount from the taxes you’d have owed on your Fortis dividends, where the tax credit is not a factor. If your marginal tax rate is 17%, you’d have owed $850 in pre-credit dividends. But thanks to the $869 credit, you end up getting a $19 refund back!
Of course, your marginal tax rate needs to be pretty low for this to work. But no matter what, the dividend tax credit saves you money, so make sure to put bonds in your TFSA first and, only after that, put dividend stocks in it.
