The question of whether the best location for Canadian Dividend Stocks is a taxable account for some provinces and tax brackets comes up regularly. As eligible dividends from Canadian stocks generate a non-refundable tax credit and reduce taxes owing in some tax brackets in all provinces, it seems logical that a taxable account would be an ideal location for holding Canadian stocks for some tax payers. For instance, dividends received by Ontario residents with a taxable income of less than $36,848 receive a dividend tax credit at the rate of 7.71% of eligible dividend received.

Before diving into the numbers, let’s make some assumptions: a pre-tax investment of $1,000 providing a return of 10% when held for 10 years. If the investment is held in a RRSP account, it is withdrawn at the end of ten years and taxes paid at the marginal tax rate. If the investment is held in a taxable account, taxes on dividends are paid every year but the investment is sold and capital gains tax paid at the end of the holding period. We’ll also make comparisons for the income, capital gains and dividend tax rates for all the Ontario tax brackets (Source: Ontario tax brackets from TaxTips.ca):

Ontario Tax Brackets for Income, Capital Gains and Dividends
  Income     Capital Gains     Eligible Dividends  
 First $36,848  21.05% 10.53% -7.71%
 Upto $40,726  24.15% 12.08% -3.21%
 Upto $64,882  31.15% 15.58% 6.94%
 Upto $73,698  32.98% 16.49% 7.44%
 Upto $76,440  35.39% 17.70% 10.94%
 Upto $81,452  39.41% 19.70% 12.91%
 Upto $126,264  43.41% 21.70% 18.71%
 Over $126,264  46.41% 23.20% 23.06%

First let us compare a RRSP account with a taxable account for non-dividend paying stocks. If the applicable tax rate is TR% and the investment is held within a RRSP, it will be worth $1,000 * 1.1 ^ 10 * (1-TR). Since investments made in a taxable account with after-tax cash, the initial investment in a taxable account is $1000 * (1 – TR). If capital gains are taxed at the rate of CR%, the investment held in a taxable account will be worth initial investment plus investment growth left after paying taxes on capital gains: $1000 * (1-TR) + $1000 * (1-TR) * (1.1^10-1) * (1-CR). Here are the results:

Difference between RRSP and Taxable Account for Non Dividend Payers
  RRSP Account     Taxable Account     Difference  
 First $36,848  $2,048 $1915 $132
 Upto $40,726  $1,967 $1,821 $146
 Upto $64,882  $1,786 $1,615 $171
 Upto $73,698  $1,738 $1,562 $176
 Upto $76,440  $1,676 $1,494 $182
 Upto $81,452  $1,572 $1,381 $190
 Upto $126,264  $1,468 $1,272 $196
 Over $126,264  $1,390 $1,192 $198

The results probably don’t suprise most of you. If anything, the results probably understate the advantage of a RRSP because most taxpayers will be in a lower tax bracket in retirement than in their working years. Even though withdrawals from a RRSP are taxed at income tax rates, which is double the tax on capital gains, a RRSP is probably the best location for non-dividend paying stocks. Note, however, that RRSP withdrawals might affect income-tested benefits such as Old Age Security and Guaranteed Income Supplement more than capital gains.

Now, let’s look at what happens when the entire return from an investment is in the form of dividends. Inside a RRSP, it makes no difference whether the returns are in the form of capital gains, dividends or a mixture of both. The analysis of a taxable account is also relatively straightforward: the rate of return is adjusted to reflect the taxes on dividends. At the end of the holding period, an investment that exclusivlely pays dividends will be worth $1,000 * (1-TR) * ( 1.1 * (1-DR) ) ^ 10, where DR is the dividend tax rate.

Difference between RRSP and Taxable Account for Pure Dividend Payers
  RRSP Account     Taxable Account     Difference  
 First $36,848  $2,048 $2,204 -$156
 Upto $40,726  $1,967 $2,028 -$61
 Upto $64,882  $1,786 $1,671 $114
 Upto $73,698  $1,738 $1,619 $119
 Upto $76,440  $1,676 $1,510 $166
 Upto $81,452  $1,572 $1,390 $182
 Upto $126,264  $1,468 $1,228 $240
 Over $126,264  $1,390 $1,116 $274

The results show that taxpayers in the lower tax brackets have some justification for holding dividend payers in a taxable account. However, though the taxes on dividends are lower than the taxes on capital gains, a taxable account is leakier for dividends than for capital gains for investors in the top tax brackets. If you think about it the reason is clear: since dividends are taxed regularly, even if it is at slightly lower rates, the effect of compounding is lost somewhat.

Unfortunately, it is rare to find investments that provide returns exclusively via dividends. In actual practice, investment returns are a mixture of dividends and capital gains. Assuming that 60% of the returns are obtained through capital gains and 40% through dividends, let’s look at how our hypothetical investment would perform in a RRSP account and a taxable account. As the analysis cannot be boiled down into a neat formula, I broke down the annual returns from capital gains and dividends, tracked the changing book values and market values and computed after-tax returns in a spreadsheet (available on request, if you want to double-check my results). It would be logical to guess that the results would fall somewhere in between the results of purely capital gains and purely dividends:

Difference between RRSP and Taxable Account for Typical Dividend Payers
  RRSP Account     Taxable Account     Difference  
 First $36,848  $2,048 $2,025 $23
 Upto $40,726  $1,967 $1,902 $65
 Upto $64,882  $1,786 $1,640 $146
 Upto $73,698  $1,738 $1,588 $151
 Upto $76,440  $1,676 $1,503 $173
 Upto $81,452  $1,572 $1,388 $184
 Upto $126,264  $1,468 $1,258 $210
 Over $126,264  $1,390 $1,164 $226

The answer isn’t as clearcut anymore. Even for the lower tax brackets (ignoring the effect of RRSP withdrawals on income-tested benefits), a RRSP comes out marginally ahead of a taxable account for the typical dividend paying stock. The notable exception is British Columbia, which provides a generous 14.36% tax credit on dividends. A BC resident in the lowest tax bracket holding a purely dividend paying stock in a taxable account would return $304 more than a RRSP account (about double that of Ontario). A stock returning a mixture of dividends and capital gains would return $32 more in a taxable account than a RRSP account. So, unless you are a BC resident in the lowest tax bracket, you might find that a RRSP is still the most efficient location for typical dividend-paying stocks.

(PS: Also check out the following articles which compared investments located within a RRSP with those in taxable accounts.
Is an RRSP contribution better than a non-registered investment or a mortgage payment? from Efficient Market Canada.
The Retirement Savings Debate from PH&N)

This article has 24 comments

  1. The tax implications of dividends is a subject that seems simple enough but one I keep tripping over. I am still not sure I fully understand how the dividend markups work. Also, I wonder how these calculations change in regard to the TFSAs? Right now I figure my income is still low enough to not worry too much about taxes here, but I’ll be on the lookout for a good guide to it.

  2. Mark in Nepean

    It seems win-win to do the following:
    1) hold CDN dividend-paying stocks in an RRSP, and
    2) hold some CDN dividend-paying stocks outside an RRSP, to take advantage of the dividend tax credit.

    Do others agree?
    Am I missing something?

    Keep up the good work CC.

  3. Excellent post. This is the sort of analysis and commentary that keeps me reading daily. Thanks.

  4. Great post CC, one also has to account for portfolio size. If someone has a large portfolio but only so much RRSP contribution room, it’s probably the most tax efficient to keep fixed income tax sheltered, but Canadian equities in a non-reg.

  5. The other posters beat me to a few key points.

    But I thought that I would point out that RRSPs are really vehicles for tax-deferral, they are not non-taxable accounts in the same way that TFSAs are tax-free. When you reach retirement, every single penny you take out of your RRSP is fully taxable as pure income, the worst possible source of income from a taxation point of view. So, does it make sense to get a tax advantaged dividend inside an account where it is eventually FULLY taxed when it is eventually drawn? Also, if you incur a capital loss inside of an RRSP, it cannot be deducted from your capital gains taxes.

    In my humble little opinion, dividend stocks should be held in a taxable account, purchased using leverage. That would give you the absolute maximum tax advantages in regards to making capital gains, take a capital loss, receive a tax-advantaged dividend or just deduct the carrying charges. However, with that being said, retirees have to be concerned about this approach because the gross-up calculation for the dividend tax credit can adversely affect the Old Age Security claw-back.

    I absolutely love the TFSA structure, but the maximum contribution is too small to worry about right now. I mean, unless you’re very young and just getting started in investing, how can one realistically compare a $5K TFSA account against a $200K RSP account or a $100K taxable account? Our TFSAs are really like a rounding error when considering our entire portfolio. Maybe a decade from now, TFSA balances may reach a level where it can be given some serious consideration. It would be nice to have the $200K in a TFSA instead of an RSP, but that’s just not possible today.

    Now, with all of the above being said… An investor shouldn’t invest based upon tax implications alone. If, for example, you run across a great stock investment opportunity and the only cash you have available is inside an RSP account, then by all means, forget the tax implications buy it inside your RSP. Same thing goes if all of your RSP money is fully invested and you find an opportunity to get a great yield on a bond, then buy it in your taxable account. Neither makes sense from a pure taxation standpoint, but we don’t have unlimited resources in all of our various types of accounts.

  6. I agree with MDJ here – portfolio size and RRSP cap room play a huge factor – If RRSPs and TFSAs are maxed, then CAN dividends paying equities are best held in non-registered accounts.

    BUT, this is an interesting exercise for those not maxing out registered account contributions – it seems like in the blogoshpere its just assumed CAN dividend payers should be held in taxable accounts. Thanks for doing the math.

  7. Canadian Capitalist

    Thanks for your comments everyone. After looking at these numbers, I’m not 100% sure anymore that if no contribution room is available, Canadian dividend stocks are best held in taxable accounts for investors in every tax bracket.

    If an investor holds non-dividend payers and has a taxable income of more than $82,000 they might be better off opting to hold non-dividend payers in their taxable accounts. (Compare the last row in Table 2 and Table 4).

    If an investor holds non-dividend paying stocks, Canadian dividend stocks, Canadian stock index funds and Foreign stock index funds, my guess of their ranking in a taxable account for investors in top brackets is:

    1. Non-dividend payers.
    2. Canadian stock index funds.
    3. Foreign stock index funds.
    4. Canadian dividend stocks.

    The reason is that index funds typically have a lower dividend yield and despite the unfavourable tax treatment in case of foreign ETFs, the greater proportion of returns from capital gains might swing the results in its favour. I’m going to run the numbers to see what I come up with.

    Of course, I agree that fixed income belongs in a RRSP for every tax bracket.

  8. I suppose the one major assumption is that the holding is held until retirement (where total taxable income will be lower than present).

    I’m guessing most people don’t liquidate non-dividend payers only after retirement when they have a lower taxable income, but many get sold over their working careers. I’m guessing it would only take a few sales for capital gains here and there for the balance to sway in favour of holding CAN dividend payers in taxable accounts.

  9. I agree with Phil S on this one.

    Personally, I hold all dividend yielding stocks outside my RRSP, to ensure that I can apply losses against capital gains. Within my RRSP, I only hold E-series mutual funds to take advantage of dollar-cost averaging, the lower MER, and because, over a 20-30 year period I’m almost assured of gains, I don’t need to worry about capital losses being “unused”.

    I like having that usable cash flow available as well.

  10. Canadian Capitalist

    @Sampson: Good point that a portfolio of non-dividend payers would still have some turnover. My assumption is that any portfolio of stocks would have some turnover but it is possible that turnover is less in mature dividend paying stocks compared to non dividend payers. Oh boy, this analysis is getting way too complicated.

    @Phil: One strategy you can adopt is do a swap between assets in a RRSP and those outside. As long as the assets are equal in value, swaps are allowed. Swaps will allow investors to locate portfolio components in the most favourable location.

  11. To cut through some of the complexity I thought I’d mention a no brainer: If your spouse is raising the kids and not earning an income, holding dividend paying Canadian stocks outside an RSP and having your spouse claim the dividend income seems like the right play.

  12. Mark in Nepean

    Good comments…interesting perspectives. Again, these types of posts are the best. Not to slog another blogs, but really, who cares about how many coupons you use in a month to save on groceries to be more frugal (err, cheap).

    A question for everyone, since NOT everyone here believes that CDN dividend-paying stocks should be in an RRSP….

    What type of RRSP do you have? Self-Directed (e.g., Waterhouse), Mutual Fund only, other? The reason I ask, since “how much you have” will depend on what type of RSP account you can own at some institutions.
    For example, for a TD Waterhouse Self-Directed (SD) RSP account, you need to have > $25 K to avoid annual fees.

    There is no value in holding a TDW SD RSP if you’re only in index funds.

    CC: I would be very interested to know what the “top” dividend yields are for index funds. Given the majority of all MFs don’t beat the index, and tracking the index is almost a sure-way to grow your holdings, I would be very keen to know what numbers you’ve crunched or going to crunch above.

    Keep the detailed insights coming gang!

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  17. Seems pretty simple to me, keep all your investments in TFSA and RRSP and then after you’ve run out of room, the government screws you over.

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  19. Mark in Nepean

    I must say, pretty funny DH!

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  21. CC,

    I ran the numbers and, perhaps because of different assumptions, calculated a different output for Pure and Typical Dividend Payers results. Not a big difference for the Pure scenario but significant difference for the Typical scenario.

    For the Pure, my formula comes out to be:
    $1,000 * (1-TR) * ( 1+0.1 * (1-DR) ) ^ 10

    This reflects the assumption that we are getting dividend income based on the value of the equity position at the beginning of the year, paying taxes on it annually, and then reinvesting the dividend at the end of the year post taxes.

    For the Typical scenario, the formulas are understandably more complex.

    I needed to calculate the Investment’s projected value and its Adjusted Cost Base in order to come up with the final after tax answer.

    The investment portfolio’s value (before Capital Gains taxes but after all dividends have been reinvested annually with any tax owing paid) is found by
    I(n) = $1,000 * (1-TR)*(1+10%*(1-0.4*DTR))^n

    ACB(n)=$1,000 * (1-TR)*(1-0.4*(1-DTR)*(1-(1+10%*(1-0.4*DTR))^(n+1)/(1-0.4*DTR))

    (Note: I actually used a more flexible formula to allow one to adjust the capital gain vs. dividend income ratio. Substitute (1-CGC) where it says 0.4 and CGC represents the Capital Gains Contribution ratio – in your example CGC would be 0.6)

    If I’ve done everything correctly, then the picture after all annual dividend taxes and after the capital gains taxes are paid the figures become:

    Pure Dividend Payers
      RRSP Account     Taxable Account     Difference  
     First $36,848  $2,048 $2,196 ($148)
     Upto $40,726  $1,967 $2,026 ($59)
     Upto $64,882  $1,786 $1,676 $110
     Upto $73,698  $1,738 $1,624 $114
     Upto $76,440  $1,676 $1,516 $160
     Upto $81,452  $1,572 $1,397 $175
     Upto $126,264  $1,468 $1,236 $232
     Over $126,264  $1,390 $1,125 $265

    Typical Dividend Payers
      RRSP Account     Taxable Account     Difference  
     First $36,848  $2,048 $2,066 ($18)
     Upto $40,726  $1,967 $1,946 $21
     Upto $64,882  $1,786 $1,691 $95
     Upto $73,698  $1,738 $1,640 $98
     Upto $76,440  $1,676 $1,557 $119
     Upto $81,452  $1,572 $1,444 $128
     Upto $126,264  $1,468 $1,314 $154
     Over $126,264  $1,390 $1,221 $169

    I trust you will point out any errors in my assumptions or calculations.

  22. Posted again hoping that the formatting will be better…

    Pure Dividend

    Income Levels   RRSP Account     Taxable Account     Difference  
     First $36,848  $2,048 $2,196 ($148)
     Upto $40,726  $1,967 $2,026 ($59)
     Upto $64,882  $1,786 $1,676 $110
     Upto $73,698  $1,738 $1,624 $114
     Upto $76,440  $1,676 $1,516 $160
     Upto $81,452  $1,572 $1,397 $175
     Upto $126,264  $1,468 $1,236 $232
     Over $126,264  $1,390 $1,125 $265

    Typical Dividends

    Income Levels   RRSP Account     Taxable Account     Difference  
     First $36,848  $2,048 $2,066 ($18)
     Upto $40,726  $1,967 $1,946 $21
     Upto $64,882  $1,786 $1,691 $95
     Upto $73,698  $1,738 $1,640 $98
     Upto $76,440  $1,676 $1,557 $119
     Upto $81,452  $1,572 $1,444 $128
     Upto $126,264  $1,468 $1,314 $154
     Over $126,264  $1,390 $1,221 $169

  23. Great post, as i am having some less information about this so your post will help me to improve my knowledge.

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