There is much enthusiasm among investors for dividend stocks these days. Some of the enthusiasm may even be warranted based on studies that have shown that dividend paying stocks have higher returns than non-dividend payers even though dividend payers have a lower standard deviation.

But there are also a lot of misconceptions about dividend payers. One widespread and persistent belief holds that Canadian dividend paying stocks should be held in taxable accounts to take “advantage” of the dividend tax credit. This belief is based on the fact that dividends receive the most favourable tax treatment for many tax brackets. For example, an Ontario resident with a taxable income of $50,000 will face a tax rate of 31% on interest income, 15.5% on capital gains and 13.4% on eligible dividends (Source: Ernst & Young 2012 Tax Calculator).

However, simply looking at marginal tax rates is a mistake. One also has to consider that dividend payments are made regularly and hence taxed at the hands of the investor each and every year whereas capital gains can be realized when the funds are needed, often after very long holding periods. To model the tax hit an investor incurs due to dividend payments, I constructed the spreadsheet available here. The spreadsheet has the following variables: the total return from stocks, the dividend yield, the tax rate on dividends and the tax rate on capital gains. The model assumes that capital gains are completely under the control of the investor. In reality, even the index fund with the lowest turnover will incur some capital gains distributions. Also, the rate of return and the dividend yield is assumed to be the same each year but as you well know, both these rates will fluctuate tremendously with changes in the level of stock prices. It is also assumed that the costs of assembling a portfolio of dividend payers is the same as that of tracking an index. As this is unlikely to be true in a real life portfolio, the model likely underestimates the effect of taxes on dividends.

If we assume that stocks return a total of 8% over a 25 year period, a $10,000 investment will grow into $68,484. Such an investment held in a taxable account will net an investor $59,420 (capital gains rate of 15.5%). As a base case, if we assume that the investment pays a dividend of 2.5%, it will grow into $57,431 (or about 2% less). Observe that even though the investor paid tax on dividends at a lower rate, they ended up with a smaller after-tax return on their original investment. If the dividend yield were 4%, the investment would have grown to $56,282. At 6%, it would grow to $54,798 and if all the stock returns were through dividends, the investment would grow to just $53,368.

It is an even worse decision for an Ontario resident with a taxable income of $100,000 to prefer dividend payers in her taxable accounts. In this case, the marginal tax rate on capital gains is 21.70% and 25.40% on eligible dividends. A $10,000 investment at 8% will grow to $55,793. If the dividend yield were 2.5%, the investment will only grow to $51,141. At a 5% dividend yield, the final amount drops to $46,990. Or look at it this way: a portfolio of stocks with a dividend yield of 5% must post total returns that is 0.40% higher than a portfolio of stocks with a dividend yield of 2.5% for an Ontario resident with a taxable income of $100,000 just to have the same after-tax returns.