Why 1-per-centers should not live on dividends alone
What will 2016 bring for Canadian investors? Two obvious trends will be a higher percentage of our aging population living off their capital, and higher taxes for wealthy Canadians.
The Globe and Mail has run many insightful articles explaining the advantages of owning stocks that pay generous and growing dividends. There is much to support this view. The payment of dividends by a company shows management’s confidence in the future of the business. Also, as an investor, it is psychologically satisfying to know that, regardless of stock price volatility, you can, over time, count on receiving a growing income stream from your investments.
Dividends from Canadian (although not foreign) companies are taxed at a favourable rate relative to interest on bonds. Because of the mechanics of the dividend gross-up and tax credit, if an Ontario taxpayer has no taxable income other than their Canadian dividends, they can receive up to about $50,000 in dividends without paying tax.
For top marginal tax rate investors, however, the analysis is more complicated.
Let’s assume that you, a top marginal rate taxpayer, are about to retire. You have calculated that, in addition to a generous pension from your former employer, you will need, for living expenses in the first year of retirement, about $80,000 – and this amount will increase with inflation each year. Thanks in part to a recent inheritance, you have $5-million of capital that you wish to invest in a portfolio of Canadian stocks.
For purposes of illustration, assume that you have only two options – investing in a Canadian stock portfolio that pays a dividend yield of 4 per cent, or one that pays no dividend. Also assume that, each year, the total before-tax return (dividends plus capital gains) for the portfolios will be the same. Which portfolio should you choose?
If you are that non-existent being, an entirely rational person, you will recognize that you do not need income in the accounting sense. Instead you need cash flow, regardless of where that comes from. You will focus on maximizing your total after-tax return over time.
This would lead you to choose the non-dividend-paying portfolio. There are two reasons for this. First, capital gains are taxed at a lower rate (about 25 per cent) than Canadian dividends (about 34 per cent). Secondly, dividends are received – and tax is paid on those dividends – when the dividends are paid by the company, regardless of whether you need the money at the time.
If you had elected the dividend-paying portfolio, you would receive and pay tax on $200,000 of dividends in a year when you need only $80,000 after tax. Had you chosen the non-dividend-paying portfolio, you would simply sell enough shares in the first year to produce after-tax proceeds of $80,000. The portion of the proceeds representing what you paid for the shares would be received tax-free, as a return of capital, and the balance as a capital gain taxed at about 25 per cent.
The comparison between receiving dividends and harvesting capital gains for cash becomes more dramatic if we assume that you, like most high-net-worth Canadian investors, want to own both Canadian and U.S. stocks. Dividends from foreign (e.g. U.S.) companies are taxed not at the 34-per-cent rate applied to Canadian dividends, but at your top marginal rate. Consequently, the above analysis is doubly true if you own U.S. stocks.
None of us is, however, entirely rational. For evolutionary reasons, our brains are hard-wired to think short term, and to be very risk-averse. When contemplating a non-dividend-paying portfolio, most people would worry about having to sell shares to raise cash in a “down year” (ignoring the fact that this would be offset by also selling in more frequent “up years”). They would also not see liquid financial assets as being effectively interchangeable, preferring the time-honoured, if illogical, distinction between capital (which we must never sell) and income. And so most people would, for perfectly legitimate psychological reasons, choose the financially inferior option.
Now let’s consider what we should do, assuming we found ourselves in the fortunate financial circumstances described above, and we were not limited to just two choices. Most of us would be best off opting for a middle ground. We would invest in a combination of stable Canadian companies that pay a healthy dividend, and higher-quality U.S. companies, most of which would pay no dividend (examples of non-dividend-payers include Berkshire Hathaway Inc. and Alphabet Inc./Google Inc.). To add a new wrinkle, we would also put any dividend-paying U.S. stocks in our RRSP, in order to defer the payment of tax on the dividends.
Such a portfolio would provide a close to optimal solution from both a financial and a psychological point of view. It would allow us, each year, to receive a portion of our living expenses as dividends from the Canadian companies, and to sell non-dividend-paying U.S. stocks to make up the balance.
A high-dividend-yielding Canadian portfolio will work well for most Canadians. However, Canada’s top 1 per cent, for whom tax will have even more bite after the end of 2015, should take the time to consider the alternatives.