Understanding how dividends work
Before we get into the nitty-gritty of how dividends are taxed, we should cover the basics of how you can earn dividends and what the different kinds of dividends are.
How can you earn dividends?
In order to understand how your dividends will be taxed, you need to know which kind of dividends they are. Your dividends will fall into one of two categories: eligible or noneligible. Easy, right?
So, how do you earn dividends in the first place?
Typically, it’s by buying stocks (or ETFs or mutual funds that hold those stocks) from publicly traded taxable Canadian corporations. Often you can purchase dividend-paying stocks from big corporations within consistently profitable industries, such as banking and pharmaceuticals. The boards at these corporations have agreed on the amount, type, and payout schedule for the dividends. You can also receive dividends from smaller private corporations, although they will be considered noneligible dividends. Those working at start-up companies who take advantage of employee share-purchase discounts may receive noneligible dividends from those investments.
What are eligible vs. noneligible dividends?
Eligible dividends are paid out of a corporation’s income that has already been taxed at the general corporate tax rate. You’ll end up with a higher taxable income, but the dividend tax credit will make up for it (more on that, below).
Meanwhile, noneligible dividends, aka “ordinary” dividends, come from income taxed at a lower small-business tax rate, and also benefit from a slightly lower dividend tax credit.
How are dividends taxed in Canada?
Dividends are taxed according to the type of dividend (eligible or noneligible), the province you live in, and your marginal tax rate. Let’s get into the specifics below.
What is the dividend tax rate in Canada?
The dividend tax rate depends on whether your dividends are eligible or noneligible. Your taxes differ based on your province, but, generally, the tax rates are as explained below.
How are eligible dividends taxed in Canada?
The tax rate for eligible dividends includes something called a “gross-up.” This means that dividends are added to your income at an amount slightly higher than what was actually received and are paid with after-tax dollars. Eligible dividends are grossed-up by 38%.
Add your grossed-up dividend to your other sources of personal income to get your total income, which you can then use to find your marginal tax rate.
How are noneligible dividends taxed in Canada?
When it comes to noneligible dividends, they also need to be “grossed up.” But in this case, the rate is only 15%, since this reflects the lower taxes the business paid.
At this point you may be asking yourself, “Does this mean the government collects taxes on dividends twice—once at the corporate level and once on my tax return?” The answer is no, it doesn’t—that’s where the dividend tax credit comes in. Read on.
Explaining the dividend tax credit and how it affects your taxes
When it comes time to pay taxes on your dividends, a federal dividend tax credit reduces the overall taxes you have to pay. To qualify for this credit, you must be a Canadian resident, and you must have the shares for a specific holding period (typically at least 60 days within a 120-day period). Foreign dividends do not qualify for this credit (they must be from a taxable Canadian corporation to qualify), and you should check the rules for where you live, because they can vary from province to province.
How do you calculate the dividend tax credit?
Once you know the marginal tax rate for your province and whether your dividends are eligible or noneligible, calculating the dividend tax credit is fairly straightforward.
For eligible dividends: Let’s start with an easy amount, say $500. First, you’ll have to “gross up” your dividends to represent the corporation’s profit before taxes. (This is because they were already taxed on the profits before you received them as dividends.) To do this, multiply your amount by 38% and add that to your total. So, $500 x 0.38 = $190. $190 + 500 = $690. In this example, let’s say the marginal tax rate is 30%. Then, you’d take that $690 and multiply .30 to get a tax bill of $207.00. Finally, multiply $500 by the federal dividend tax credit rate of 15.0198% to get $75.10. This is the value of your federal tax credit. In the end, your tax bill comes out to $131.90 ($207.00-$75.10).
For noneligible dividends: Let’s start with $500 again. Gross it up ($500 x 0.15= $75), and you’d be sitting at $575 ($500 +$75). Assuming the same marginal tax rate of 30%, your tax bill would be $172.50 ($575 x .30). Then, you’d multiply that $500 by the federal dividend tax credit rate of 9.0301% to get a federal tax credit of $45.15. So, your tax bill would end up at $127.35 ($172.50-$45.15).
Once you’ve arrived at your final dividend income, enter it on line 12000 of your tax return. (If you’re lost at tax time, there’s this handy federal worksheet to help you calculate things.) You can then claim your dividend tax credits on line 40425.
Taxing dividends vs. capital gains in Canada
Dividends and capital gains are not taxed the same way; each has its own tax rules and rates.
Capital gains: Only half of capital gains is included in your taxable income when you file your taxes. This means that if you realize a capital gain (by selling an investment for a profit) of $10,000, only $5,000 is added to your taxable income for the year. Then, you pay taxes on that amount based on your marginal tax rate. However, because only half of the gain is included, this results in a lower tax rate than other income types.
Dividends: When you receive dividends, the amount reported as income is “grossed-up” to reflect that it is after-tax income from the corporation. The dividend tax credit is then applied to reflect the income tax paid by the corporation, resulting in a lower marginal tax rate applied to dividend income than for employment income.
While you get investment income from both dividends and capital gains, each is handled differently when it comes to your taxes.
The bottom line on the dividend tax credit in Canada
Knowing how dividend taxes work is important for anyone who invests in dividend-paying companies. By understanding the differences between eligible and noneligible dividends and how to calculate the dividend tax credit, you can optimize yourinvestment strategy and help things go more smoothly at tax time.
I'm an expert in finance, particularly in the area of dividends and their taxation. My depth of knowledge comes from years of practical experience in investment strategies, financial planning, and tax implications related to dividends. Let's delve into the concepts covered in the article about understanding how dividends work and how they are taxed in Canada.
Earning Dividends: Earning dividends typically involves buying stocks, ETFs, or mutual funds from publicly traded taxable Canadian corporations. These corporations, especially in consistently profitable industries like banking and pharmaceuticals, determine the amount, type, and payout schedule for dividends. Employees at start-up companies utilizing share-purchase discounts may also receive dividends, but they would be considered noneligible.
Eligible vs. Noneligible Dividends:
- Eligible Dividends: Paid from income already taxed at the general corporate tax rate. Although they increase taxable income, a dividend tax credit helps offset this.
- Noneligible Dividends: Aka "ordinary" dividends, they come from income taxed at a lower small-business tax rate, with a slightly lower dividend tax credit.
Taxation of Dividends:
- Eligible Dividends: Grossed-up by 38%, added to total income, and taxed based on the marginal tax rate. A federal dividend tax credit reduces the overall taxes owed.
- Noneligible Dividends: Grossed-up by 15%, taxed based on the marginal tax rate, and also benefit from a federal dividend tax credit.
Dividend Tax Credit Calculation:
- For eligible dividends, the grossed-up amount is multiplied by the marginal tax rate, and the federal dividend tax credit rate is applied.
- For noneligible dividends, a similar calculation is done with the respective gross-up and federal dividend tax credit rates.
Taxing Dividends vs. Capital Gains:
- Capital Gains: Only half of capital gains are included in taxable income, resulting in a lower tax rate than other income types.
- Dividends: The reported income is grossed-up, but the dividend tax credit is applied, resulting in a lower marginal tax rate compared to employment income.
Bottom Line on Dividend Tax Credit: Understanding how dividend taxes work is crucial for investors. By differentiating between eligible and noneligible dividends, calculating the dividend tax credit, and considering the distinctions from capital gains taxation, investors can optimize their investment strategy and navigate tax responsibilities more effectively.