This blog post is adapted from my French column with the newspaper Les Affaires.

For or against high-dividend equity funds? Oh, come on, no one can be against dividends! But wait, the darling of so many fund holders and other investors does not provide only upside. Let’s take a look…

Advantages

Dividends are reassuring

Investors who do not have complete confidence in the stock markets may say to themselves: “If I don’t generate gains with my portfolio for a while, with dividends, at least I’ll be paid for waiting.” They think that a high dividend-distribution rate confirms that the company is making profits and shows a level of confidence in the future. In addition, companies listed on the stock market are often very reluctant to cut their dividends. So, regular dividend distributions represent a commitment that can be reassuring.

High dividends promote discipline

Perhaps because dividends boost confidence, investors tend to hold their high-dividend equities longer than other securities. In addition, studies show that high-dividend equity funds enjoy the highest survival rate of all fund categories. Investors are extremely loyal to this type of fund. They are more patient and persevering in their investment strategy.

Dividends of Canadian public corporations benefit from a tax credit

Consequently, their tax rate is lower than for interest income. But which of Canadian dividends and capital gains are the least heavily taxed? It depends. For the range of taxable income below $45,000, the marginal tax rate for an individual taxpayer in Québec is distinctly lower for dividends than for capital gains. From $45,000 to $85,000, it is nearly equal, and above $85,000, capital gains are taxed at the lowest rate. And the more your income exceeds this threshold, the bigger the difference, as shown in the table below. Keep in mind that dollars that you pay in taxes cannot be used to pay for groceries!

Marginal tax rate for 2016

Taxable income Tax rate for Canadian company dividends Tax rate for capital gains
$15,000 – $42,000 5.6% 14.3%
$42,000 – $45,000 11.2% 16.3%
$45,000 – $85,000 17.5% 18.6%
$85,000 – $90,000 23.0% 20.6%
$90,000 – $103,000 29.4% 22.9%
$103,000 – $140,000 31.8% 23.7%
$140,000 – $200,000 35.2% 25.0%
$200,000 and over 39.8% 26.7%

Source: Raymond Chabot Grant Thornton – Tax Planning Guide

Figures are rounded for simplicity.

Disadvantages

Loss of diversification

Believe it or not, most equities listed on the stock market pay only minimal or no dividends. And the fact that a stock pays a very high dividend is no guarantee of quality. A large number of companies that don’t pay dividends are very profitable. And, conversely, often companies in trouble persist in paying fantastic dividends. By insisting on high-dividend securities, you substantially limit your potential for diversification and, consequently, risk control.

A dividend is not a gift

Generally, when the eligibility date for a dividend payment expires, the share price falls by almost an equivalent amount. Let’s say, for example, that a share trading at $10 is about to pay a dividend of 25 cents; the price will fall to $9.75 the day after the distribution. Each dividend paid reduces the share price by as much, and in the long term lowers its potential for capital gains. If you are invested for the long term, notwithstanding taxes, you should be indifferent to the payment of dividends. Whether the money is distributed to you or reinvested in the company, it belongs to you anyway. Only the way in which you own it is different.

Taxation of dividends from foreign companies is very disadvantageous

Foreign dividends are taxed at the full rate for ordinary income, or the same rate that is applied to interest income. In addition, foreign governments apply withholding tax to dividends paid to residents of other countries, like Canadians for example. This withholding is typically around 15%. And even RRSPs and RRIFs are affected by these withholdings, which are nonetheless recoverable. But, ultimately, income from foreign dividends is much more heavily taxed than income from Canadian dividends and capital gains.

Conclusion

It would be misleading to believe that high-dividend equities are superior in all circumstances. Dividends can offer you a certain level of reassurance and encourage you to persevere with your portfolio strategy. But, companies that pay high dividends are not inherently superior to others. From a tax standpoint, dividends from Canadian companies may prove to be very advantageous or, on the contrary, very disadvantageous compared to capital gains, depending on your income level. Foreign-source dividends are heavily taxed. In addition, a strategy centered on high dividends greatly limits the ability to diversify your portfolio.

Text box: Action plan

High-dividend mutual funds or equity ETFs may prove to be advantageous when:

  • You tend to give up on your investment strategy during periods of turbulence and the presence of high dividends helps you stay on course.
  • You have significant non-registered investments and you report personal income of less than $45,000.

High-dividend mutual funds or equity ETFs should be avoided when:

  • You are indifferent to the “charm” of dividends and instead want to maximize your portfolio’s diversification and after-tax returns.
  • You have significant non-registered investments and you report personal income of more than $85,000.