Why are dividends considered to be so important? After all, it’s not as if investors gain anything from the dividend, because the stock price adjusts lower (all else being equal) on the ex-dividend date. I realize the dividend tax credit is a major advantage, but are there any other advantages?
This is a great question. First, I’ll elaborate on the dividend tax credit. Then I’ll discuss some of the many other benefits of investing in dividend stocks.
Dividends give you “credit”
The reader is correct that a dividend, in and of itself, does not create any value. Dividends are paid out of a company’s after-tax earnings, so a dollar per share gained by the investor is one dollar per share less in the company’s coffers. That’s why, at least in theory, on the ex-dividend date the share price should fall by the amount of the dividend. It rarely works out exactly that way, however, because many other factors affect a company’s stock price.
But the way dividends are taxed does benefit investors. The dividend tax credit, in effect, gives investors “credit” for the tax already paid at the corporate level. As a result, personal marginal tax rates for dividends are substantially lower than tax rates for interest and other income.
In Ontario, for example, an individual with $100,000 of taxable income for 2022 would pay combined provincial and federal marginal tax of 17.79 per cent on eligible dividends, compared with 37.91 per cent for regular income. (Dividends are also taxed at a lower rate than capital gains, although the reverse is true at incomes above $100,392 in Ontario. Visit TaxTips.ca to see marginal tax rates for every province.)
At lower income levels, dividends have an even bigger advantage. Someone with $60,000 of taxable income in Ontario would pay tax of just 6.39 per cent on dividends, versus 29.65 per cent on interest or other income. At taxable income of $50,197 or less, the marginal tax rate on dividends is actually negative. Because the dividend tax credit is a non-refundable credit, the government won’t send you a cheque for the negative amount. But you can use it to offset your other taxes owing.
Dividends reward good behaviour
One of the worst things an investor can do is trade frequently. Not only does it drive up commission costs and taxes, but it can lead to mistakes such as chasing overvalued stocks or selling perfectly good companies when their shares have hit a rough patch. Selling to “lock in a profit” is another common mistake. Often, simply buying and holding a great company through good times and bad is a more profitable – and less stressful – strategy.
Dividends are a great way to develop buy-and-hold discipline. If you know you’ll be receiving a dividend next quarter – and that the company has a track record of increasing its payout – you’ll be more inclined to stay invested to keep the cash flowing into your pocket. Dividends also help investors cope with market turmoil. Even as share prices bounce up and down, dividends for many companies – such as banks, utilities and consumer companies – are very stable.
Dividends can keep you out of trouble
It’s normal to feel envious when your friends are making a killing on stocks such as Shopify Inc. (SHOP) and Netlix Inc. (NFLX). But when was the last time you saw a utility or pipeline lose more than 70 per cent of its value in the span of five months? That’s what happened to both of these formerly high-flying stocks after the market decided the tech party was over.
True, dividend stocks can suffer losses, too. But the odds of a similarly crushing decline for a utility such as Fortis Inc. (FTS) or a pipeline such as TC Energy Corp. (TRP) are remote. That’s because their earnings are more predictable and their valuations are generally more reasonable, instead of being based on optimistic growth assumptions. Companies with stable and growing dividends are also typically solid businesses on the conservative end of the risk spectrum.
What’s more, a stable and well-covered dividend can help to limit the downside for certain stocks because the yield – which rises as the share price falls – may attract more buyers.
Growing dividends help you fight inflation
I don’t need to remind you that prices for everything from gasoline to groceries are going through the roof. With Canada’s inflation rate hitting a 31-year high of 6.7 per cent in March, people are watching their purchasing power get eaten alive. But the damage isn’t as bad for investors who own stocks with rising dividends. To take one example from my model Yield Hog Dividend Growth Portfolio, Brookfield Infrastructure Partners LP (BIP.UN) in February raised its distribution by 6 per cent, continuing a pattern of annual increases. The vast majority of other stocks in the model portfolio have also raised their dividends at least once in the past year. (Note: BIP.UN’s payment isn’t strictly a dividend; to get the full benefit of the dividend tax credit, you’d need to invest in its sister company, Brookfield Infrastructure Corp., ticker symbol BIPC.)
Dividends are part of a well-balanced investing diet
Variety is the spice of life, and that’s also true for investing. In my personal portfolio, I also hold broad Canadian and U.S. index exchange-traded funds to get exposure to other sectors such as technology, energy and materials that don’t typically pay big (or stable) dividends. Diversification helps to blunt the fear of missing out when these sectors are rising, and it also limits the damage when previously hot sectors cool off, as we’ve seen recently with technology.
By owning dividend stocks, you can keep your taxes low, control your urge to trade and keep your emotions in check during turbulent times. Best of all, as the growing stream of dividend cash flows into your brokerage account, you can experience the thrill of getting paid to do absolutely nothing.
Full disclosure: The author personally owns shares of FTS, TRP, BIP.UN and BIPC.
E-mail your questions to jheinzl@globeandmail.com. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.
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John Heinzl