How dividends deliver big tax savings

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In my other role as The Globe's Yield Hog columnist, I talk a lot about the benefits of investing in stocks with growing dividends.

Well, getting more income is great – I highly recommend it – but it's not the only benefit of dividend investing. Thanks to how our tax system works, you also get to keep more of that money in your pocket than you would with, say, a bond or guaranteed investment certificate.

This being tax season, let's take a closer look at dividend taxation, including the theory behind it and how it results in low marginal rates on dividend income.

Dividends are taxed lightly

The marginal tax rate on dividends depends on your income level and province, but it's always lower than the marginal rate on interest or employment income. For example, an Ontario resident with $100,000 of taxable income from all sources in 2014 would pay a marginal rate of 43.41 per cent on interest but just 25.38 per cent on eligible dividends, according to Tax Tips.

At lower income levels, the tax rate on dividends drops dramatically. If you have $80,000 of income in Ontario, for instance, the marginal rate on eligible dividends is just 10.99 per cent. And if your 2014 taxable income is $43,953 or less, your marginal rate on dividends will actually be negative (I've written about this before: Investor Clinic).

Taxtips.ca has tables for all the provinces and territories, so you can look up the marginal rates applicable to your situation.

Now let's look at the math behind these numbers.

Understanding the gross-up

Many investors realize that, for tax purposes, their dividends are "grossed-up" by a factor of 1.38. For example, if you receive a dividend of $100 (reported on your T5 slip as the "actual amount of eligible dividends") this amount is multiplied by 1.38 to become $138 (reported on your T5 as the "taxable amount of eligible dividends"). What a lot of people don't understand is why.

Here's the reason: When a company sends you a dividend, the money is paid out of its after-tax profits. As a shareholder, you shouldn't have to pay taxes again on the company's profits – these profits, after all, belong to you as a part-owner of the business. Taxing them twice wouldn't be fair.

The purpose of the gross-up – and the dividend tax credit, which I'll explain shortly – is to avoid double taxation. In effect, the gross-up converts the value of your dividend to the approximate amount of profit, before taxes, the company had to earn to pay you the dividend. In the example, to generate that $100 dividend, the company had to earn about $138 before tax.

Credit where it's due

On your return, you are taxed at your regular marginal rate on that $138. Lousy deal, right? You didn't actually receive $138. But then the government throws you a bone: It credits you for the approximate amount of tax the company has theoretically already paid on that $138. The federal dividend tax credit (DTC) is 15.02 per cent of the grossed-up dividend. On top of that, provinces kick in their own DTC that ranges from about 8 per cent to 12 per cent (10 per cent in Ontario).

Continuing with the example, if you live in Ontario and your marginal tax rate on regular income is 43.41 per cent, your tax on the grossed-up dividend would be $59.91 (43.41 per cent of $138). You would then apply the combined federal and provincial dividend tax credit of $34.53 (25.02 per cent of $138), which would reduce the tax hit to $25.38 (which is 25.38 per cent of the $100 in cash you actually received).

How can the tax rate on dividends be negative? Well, as you move down the income ladder, the marginal rate on regular income eventually drops below the rate of the combined dividend tax credit. In Ontario, the cross-over point happens at $43,953 of 2014 income, when the marginal rate on regular income is 24.15 per cent – lower than the combined DTC of 25.02 per cent.

The government won't actually write you a cheque for the negative amount, because the dividend tax credit is non-refundable. But negative taxes on dividends can reduce other taxes payable.

Phantom-income pain

One downside of the gross-up is that it makes one's income look larger than it actually is, which can in some cases result in a reduction of Old Age Security (OAS) and various tax credits. However, the OAS clawback, which kicks in at $71,592 of income for 2014, affects only about 3 per cent of the retired population. What's more, the impact on the clawback is modest: For someone reporting $138 of grossed-up dividend income versus $100 in interest, the incremental clawback would be $5.70.

Sure, reporting phantom income seems unfair. But it's integral to the dividend gross-up and tax credit system, which for most people provides welcome tax relief.