So what are dividends, anyway?

Once upon a time, capital gains were the most tax-effective way to receive investment income in Canada. But then Ottawa consigned the $100,000 lifetime capital gains exemption to the tax department trash bin and everything changed.

Now the tax-smart way to earn investment income is through dividends. Capital gains still get a tax break, but no matter what your level of income, a dollar’s worth of dividends from a taxable Canadian corporation will leave more money in your pocket than a dollar in capital gains or interest. In fact, interest receives no tax advantage at all.

The higher your tax bracket, the greater the gain.

Averaging out the various tax rates across the country, a top-bracket Canadian taxpayer has to earn about $1.40 in interest income to generate the same after-tax return as $1 in dividends. That’s a major-league difference.

The dividend tax advantage comes from what’s called the federal dividend tax credit, allowed because dividends are paid out of a company’s after-tax earnings. This reduces the double taxation resulting from the fact that dividends are taxed again after you or I receive them. This credit is not available within registered plans su as RRSPs or RRIFs, but anyone investing for income outside such a plan should seriously consider holding some dividend-generating securities.

And yes, that does mean buying shares, but you can switch from interest-bearing investments to those that pay dividends without a lot of risk. But what exactly are dividends? I don’t believe in investing in anything I don’t understand, and most people think dividends are far too complicated. The fact is, there’s really no great mystery. Following are answers to the most common questions:

What are dividends?
Dividends are a portion of after-tax profits paid to shareholders by corporations. They can be received by both common and preferred shareholders, the difference being that common shares usually represent a voting interest in the company, and their value rises and falls with that of the company. Preferred shares are almost always non-voting. The preferreds usually pay a fixed dividend, which is the key factor in deciding how much they’re worth.

Who decides what a dividend will pay?
For common shares (basic stock with a vote) the amount is chosen by the company’s board of directors based somewhat on how much profit the company makes. Some companies believe in paying out a big chunk of profit to shareholders. Others pay puny sums and keep the cash to expand operations or reduce debt. Dividends for preferred shares are usually fixed at a set percentage of profit.

How can I invest in dividend-yielding stocks with relative safety?
There are three alternatives:

1) Through preferred shares, which usually offer the highest dividend yields. I like those issued by banks and utilities because they usually provide the best combination of return and safety.

2) Through high-yielding common shares: Bank, utilities, pipelines and some industrial common stocks offer steady dividend payments. Yields are lower than preferred shares issued by the same companies, but the common stock has more potential for growth.

3) Through mutual funds: Some funds are specifically designed to provide dividend income. If they have good track records, I believe they’re the best route for the average investor because professional money managers choose the securities and keep them in proper balance.