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The Tax Drag of Dividends

It is regularly pointed out that stock market dividends have fallen significantly from what they were 20, 40, or 60 years ago. At one time it was normal for stocks to yield more than bonds. That didn’t happen in major markets from the 60s up to 2010. But that dividend yield in 2010 that once again topped the bonds was much lower than the dividends you could get even 20 years ago. It’s now normal for US stocks to yield about 2% and other markets about 3 – 4%.

Some people react to this by saying that stocks are simply overvalued because investors are willing to accept such a low yield. If prices fell by a lot then the dividend yield could rise to a good 4 – 6% as it did in 2009. While that is true, it doesn’t mean that stock markets are about to crash. This analysis is overlooking the fact that part of the lower yield is intentional. In recent years preferences have turned to capital gains over dividends, and a major reason is taxes.

Dividend Taxes

I’m not familiar with all the US tax laws but it sounds like the tax treatment of dividends has varied quite a bit over the past decade, from being favorable to being one of the worst forms of income. Here in Canada, of course, dividends are a long-favored form of retirement income because of their consistently low taxes. In the end that isn’t as good as it sounds since individual investors are just being taxed for the corporation’s pre-tax earnings and part of that tax has already been paid. Like many other things there is a hidden tax that most people aren’t aware of.

Capital gains have consistently had tax advantages in both countries (again the US has varied more). Because of this and the fact that dividend taxes have to be paid every year while capital gains taxes are only paid at the time you sell an investment, dividends often result in paying more taxes earlier than an equivalent amount of capital gains. This is complicated even further by tax shelter accounts.

Tax Free (Except For…)

In Canada it is very tricky to navigate the various combinations to avoid paying taxes on foreign dividends. In a TFSA you will lose some taxes on any foreign dividend, and sometimes get taxed twice (yes, double taxation in the Tax Free account exists) if you’re holding a US ETF with international stocks. In an RRSP you can avoid the US taxation but you still lose most international taxes.

I’ve been going through the options to figure out which ETFs we want to buy and where. As a result the RRSP account holds VXUS (total stock market, non-US) since it has the highest yield of the foreign indexes we want to own and the RRSP avoids US taxation. The TFSAs have more VXUS, VTI (US total stock market), and the Canadian ETFs ZCN and ZRE. Only those Canadian ETFs will be truly tax-free. This seems like the best way to minimize taxes on dividends which is a funny thing to have to do in a tax-sheltered account.

The taxes involved here aren’t very large. The US withholding amount typically seems to be 15% and that’s only on the dividends. Other countries may take different amounts. I’ve heard the average withholding tax on the EAFE index is around 12% or less. If you held $100,000 of VXUS in a TFSA at a dividend yield of 3%, the withholding taxes might cost you $810/year. In an RRSP you would only lose $360/year. To put that in perspective, switching $100,000 from the e-Series EAFE fund to VXUS would save you $350/year in management fees.

I don’t think this taxation is enough to switch to all Canadian stocks and lose the diversification. An international portfolio which can hold 9000 stocks in 2 ETFs, while ZCN has less than 300. It is worth avoiding that US withholding tax wherever possible though. If you’re holding ETFs in a taxable account then you can get most or all of the withheld taxes back, but it takes more work and you still end up having to pay the regular tax on the dividends.

Capital Gains Save Money

As this shows minimizing the taxes on dividend income can range from difficult to impossible. This is one reason that investors and corporations, especially in the US, are favoring capital gains instead. Corporations can convert dividends to capital gains by using their cash to invest in the business, buy other companies, or buy back shares instead of paying a dividend. With these options the corporation can also defer taxes (I think share buybacks are the exception).

This move to prefer capital gains should save investors from some taxes. However dividends have one big advantage: putting cash in your account that dumb executives can’t lose. With the increasing reliance on capital gains we have to trust that the company’s stock price and earnings are reasonable and accurate and that it is well-managed. When I’m allocating these ETFs I’m glad that the dividends are fairly low, but that means I’m relying a lot more on someone else being willing to buy at a higher price in 10 or 20 years. That is an increased risk to investors no matter how you look at it.

It may still be true that investment income is taxed more lightly than working income, though part of that is because taxes have already been paid and you just aren’t counting them. It’s certainly not easy to make that a reality for yourself.

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