TFSA Investors: Here’s the Only Time Using a Taxable Account Is a Better Choice

Did you know that there are times when holding investments in a taxable account is preferable to holding them in a tax-free savings account (TFSA)?

It might seem hard to believe, but it’s true.

If you have a diversified portfolio consisting of dividend stocks, bonds and growth stocks, you may actually be better off putting the dividend stocks in a taxable account.

Here’s why.

The dividend tax credit

If you hold dividend stocks alongside growth stocks and bonds, the former asset type needs your TFSA room more than the latter two do. There are two reasons for this:

1. Eligible Canadian dividend stocks get the dividend tax credit anyway, meaning there is a certain amount of tax protection built into them.
2. Growth stocks, while enjoying some tax protection of their own, sometimes produce outsized returns in short order. In situations like this, they benefit from being tax sheltered.
3. Bonds are taxed more than stocks, enjoying neither the dividend tax credit nor the capital gains exclusion rate. For this reason, they benefit significantly from being tax-sheltered.

Basically, dividend stocks enjoy two built-in features – the dividend tax credit and capital gains exclusion – that give them more default protection than growth stocks or bonds. In the next section, I will use a real world example to show how this works.

An example

To illustrate the effect that the dividend tax credit has on a stock, we can imagine that you hold $100,000 worth of Fortis (TSX:FTS) stock in a taxable account. Fortis is a dividend stock with a relatively high and stable yield, making it a good example to work with here.

Fortis pays a regular dividend of $0.64 per quarter. That works out to $2.56 per year. Fortis’ stock price was $76.48 at the time of this writing. Therefore, the yield was 3.4%, and an investor holding $100,000 worth of FTS stock would bring in roughly $3,350 in annual dividends. Here’s the math on that:

Now, here’s how those dividends would be treated in a taxable account, on the assumption that you’re in the first tax bracket (15%).

1. The dividend income would be “grossed up” by 38%, to $4,620.90.
2. The federal tax would be calculated as $4,620.90 times 15%, which is $693.13.
3. The federal dividend tax credit would be calculated as $4,620.90 times 0.150198, which is $694.05.
4. The federal tax would be reduced to zero!
5. A provincial tax and DTC would be applied. This one varies by province, so I’ll skip it to avoid possible confusion.

As you can see, the dividend tax credit has the power to reduce dividend taxes to zero. If your tax rate is low, you don’t necessarily need to use up precious TFSA room on Canadian dividend stocks. Better to save it for growth stocks or bonds.

Now, speaking of growth stocks: those do enjoy the benefit of capital gains exclusion. The capital gains exclusion rate exempts a portion of your capital gain from taxation; the rate is 50% currently. So a Fortis shareholder with a 15% tax rate, would actually pay only 7.5% on any capital gains on the stock. Both dividend stocks and growth stocks get this benefit. Dividend stocks get the exclusion rate and the tax credit, though, so they are of lesser priority than growth stocks and bonds for TFSA inclusion.