Dividends, taxes and the investor

Value oriented investors are well aware of the positive effects dividends have had on their total returns over time.  A company’s board of directors may decide to pay a dividend to one or more of their class of shares.  They then select a date – referred to as the record date – to determine which shareholders are eligible to receive the dividend.

Dividends are usually paid quarterly and are more common among mature businesses that do not require all of their profits to fund future growth.  Growth oriented companies are less likely to pay dividends as they retain their capital to fund internal growth and in some cases make acquisitions.

Looking at Yield

Yield is often a term associated with value companies (those that pay a dividend).  As noted above, dividends are normally stated as a monetary amount, i.e. $0.50 per share.   If the company pays this quarterly then the total dividends for the year are $2.00.  If the share price is currently at $80, then the yield is 2.5 per cent (2/80).  If the price of the share increases to $100, then the yield drops to 2 per cent (2/100).   If the price of the share decreases to $60, then the yield increases to 3.3 per cent (2/60).

2006 Federal Budget

The 2006 federal budget contained a number of proposed changes to personal and corporate income tax.  One proposed change we would like to highlight is with respect to dividends.  Dividends paid by Canadian public corporations after 2005 will be subject to a 45 per cent gross-up (previously 25 per cent) and a federal dividend tax credit of 19 per cent of the grossed up amount (previously 13.33 per cent).  This change is good news for many investors.

Dividend Gross-Up

This confuses most investors who are trying to do their income tax return for the first time.   The common question asked is that if I received $100 in dividends, why am I taxed as if I received $125 (after 2005 $145).  With the “gross-up” amount you apply your marginal tax rate.  The highest marginal tax rate (combined provincial and federal) in British Columbia for 2005 was 43.7 per cent.

Dividend Tax Credit

What is a tax credit?  The most important component to note is that “credits” are better than deductions.  A credit is generally a dollar for dollar deduction from taxes payable.

Illustrations

Let’s consider an individual who receives $1,000 in dividend income and assume they are subject to highest marginal tax rate and that other income exceeds the basic exemption.

dividends

Investors who continue to receive dividends from Canadian corporations will now end up taking more income home.  Individuals with only registered accounts or hold securities that do not pay dividends will not benefit from this proposed change.

Investors 65 and Over

Individuals 65 and older may qualify for Old Age Security, Age Credit and other government benefits.  In order to qualify for these benefits the government will look at certain line numbers on the tax return to ensure your income is below certain thresholds.  If an individual’s income is too high then these benefits may be reduced or completely eliminated, this is often referred to as the “claw back.”   The increase in the gross-up amount of the dividend may have a muted effect for investors 65 and older.  Although these investors may receive more of their dividend income they may see a portion of their government benefits eliminated or clawed back.  Obtaining an understanding of the various claw back provisions is important to avoid cash going in one pocket while being taken away from another.

A Little Planning

As with every change to the taxation of investments, individuals need to structure their portfolio in a manner that creates the most efficiency.  It is what goes in your pocket at the end of the day that is most important.  Our column next week will highlight a few strategies and compare different sources of income and the related tax benefits.

Before implementing any strategies discussed in our columns we recommend that you speak with your financial and tax advisors.

 

RESPs – Not just for kids

There are no age limits for Registered Eductation Savings Plans.  RESPs are often set up by adjult subscribers for the benefit of usual children or grandchildren.  But adults can name themselves as the subscriber and beneficiary. 

It is more common for individuals to change careers as a result of displacement or a desire to do something different.  In fact many are now working into their retirement years.  Furthering your education may allow you to pursue different opportunities that are both satisfying and rewarding.  The potential to increase your income may also be an attractive incentive.

An RESP is a great savings vehicle for adults planning to go back to school, couples with different income levels wishing to split income and investors wishing to defer investment income.

RESPs for Adults

The steps for opening a non-family adult RESP is very similar to opening an RESP for an individual child or family RESP.  You simply name yourself both the subscriber and the beneficiary.  Individuals may contribute up to $4,000 annually ($42,000 maximum contributions to the plan). Unfortunately adults are not eligible for the Canada Educations Savings Grant.  The following outlines why RESPs for adults are still worth considering for some.

Comparing RESPs to RRSPs

Both RESPs and RRSPs provide tax deferral benefits.   While similar in many respects, the following highlights the main differences:

  • RESP contributions are not deductible, where RRSP contributions are deductible
  • RESP contributors may withdraw their original capital at any time with no tax consequences, whereas withdrawals from an RRSP/RRIF are generally considered taxable income
  • RESPs must be terminated within 26 years after plan start date and individuals are not forced to withdraw funds after age 69; with an RRSP you must convert to a RRIF at age 69 and begin taking payments at age 70.

Withdrawing Income

The easiest way to withdraw income generated in the RESP is to be enrolled in a qualified post secondary institution.  After enrolment you may begin receiving Educational Assistance Payments (EAP).  In RESPs for adults, an EAP is a distribution of the accumulated investment income that is taxed in the beneficiary’s hands the year in which it is received.  Adults are not eligible for the Canada Education Saving Grant.  The EAP includes income only and no Grant portion.

Enrolling in School

In order for a beneficiary to qualify for an EAP the individual must be enrolled in a post-secondary program at a qualifying educational institution.  For institutions within Canada the program needs to be at a minimum ten hours a week for three consecutive weeks.  For institutions outside of Canada, the minimum is increased to 13 consecutive weeks.   The amount of the EAP is limited to the lesser of $5,000 and the actual expenses for the first 13 consecutive weeks.  There are no limits on the dollar amount of the EAP after 13 weeks.

Failure to Enroll

An individual may withdraw their original capital at any time with no tax consequences.  If not enrolled at a qualifying institution within ten years the individual can qualify for an Accumulated Income Payment (AIP) that represents the investment earnings in the RESP.  An AIP withdrawal is subject to a penalty tax of 20% in addition to the taxes payable when taken into income.  Other rules relating to the termination of the RESP after the first AIP payment also apply.  Individuals with RRSP contribution room available have an option to transfer up to $50,000 into their RRSP or to a spousal RRSP. This option avoids the 20% penalty tax and may provide a unique income splitting opportunity.

Interesting Points to Consider

Although the 20% penalty may be a determent for some, we feel it shouldn’t be.  Finding an economical course that lasts more than 13 consecutive weeks is an easy way to avoid the penalty.  The following are some interesting points to consider:

  • Correspondence courses qualify
  • Individuals are eligible for the EAP regardless of whether they attend classes
  • Individuals are eligible for the EAP even if they do not successfully complete the course
  • Individuals may be eligible for education and tuition tax credits

RESPs are not just for your children.  In fact, it might be your gateway to an exciting new career!