Recently I received an email from a reader who is interested in generating more tax-advantaged income from his investment portfolio.
“I am retired and dependant on my portfolio for income,” he wrote. “Recently I read an article titled ‘The secret to tax-free living’. The gist of the article was that it is possible to earn up to $45,000 (grossed up to $65,000) in some provinces essentially tax-free provided the income is from dividends from Canadian corporations. The article goes on to promote a strategy that emphasizes investing in companies that pay dividends and in particular companies with a history of increasing dividends. I know you have recommended such stocks in your newsletters. I have two questions relating to an income-oriented portfolio:
“1) Do you agree with the ‘tax free living’ concept outlined above?
“2) Given an apparent reduction in risk associated with investing in large Canadian dividend paying corporations, what do you think of increasing the percentage of these dividend stocks and income trusts at the expense of the fixed-income portion of the portfolio?”
With regard to the first question, the answer is yes, it is possible to receive a significant amount of dividend income tax-free. According to tax tables published by the accounting firm of Ernst & Young, residents of British Columbia, Saskatchewan, and the Territories can earn up to $46,600 a year in income without paying any tax. This breaks down to $37,000 in dividends and $9,600 in other income (such as CPP payments) which would be sheltered by the personal exemption. The tax-free amounts for other provinces are slightly less, but the principle is the same.
However, don’t lose sight of the fact there are two different types of dividends. The figures I’ve quoted relate to “eligible dividends” – basically, those paid by large taxable Canadian corporations. “Ineligible dividends” are those paid by small companies that qualify for the small business tax rate. Dividends from U.S. companies don’t receive any tax break in Canada, nor do any dividends paid into registered plans.
As far as income trusts are concerned, many don’t offer much tax sheltering. For example, last year 94 per cent of the distributions paid out by Yellow Pages Income Fund were fully taxable. As a general rule, REITs are the best bet if tax-sheltering is a primary objective.
So does this suggest that investors should increase their exposure to dividend-paying stocks and REITs at the expense of fixed-income securities, as the reader suggests? Maybe – but only if you’re willing to assume more risk. Even the most conservative stocks and trust units will carry more risk than a high-quality bond. So a portfolio that is poorly diversified in terms of asset class exposure will be more vulnerable in market downturns. For example, portfolios that were top-heavy in equities took a big hit during the November market correction but those with large fixed-income holdings fared much better as bond prices rose during the month.
Using preferred shares to enhance dividend income reduces the risk to some extent, but even they can experience price drops if interest rates rise, the company is taken over (BCE is a case in point), or new issues temporarily saturate the market.
Some examples of high-quality dividend-paying stocks include utilities such as Fortis and Canadian Utilities, the major banks, and pipeline companies such as TransCanada. Among the REITs, RioCan has always been one of my favourites and it currently yields 5.9 per cent. Talk to a financial advisor to see if any of these are right for your needs.
Just don’t lose sight of the fact that even though all these securities are top-grade, they carry more risk than bonds, so don’t go overboard.
This article originally appeared in the Internet Wealth Builder, a weekly e-mail newsletter that provides timely financial advice from some of Canada’s top money experts. For more information about becoming an Internet Wealth Builder member, go to http://www.buildingwealth.ca/promotion/50plusproducts.htm