Dividends in a TFSA vs. a Non-Registered Account: What's the Difference?

Dividends in a TFSA vs. a Non-Registered Account: What’s the Difference?

Explore the advantages of TFSA and understand how to invest wisely to minimize your dividend tax load in Canada.

Puja Tayal

Author Bio

Puja Tayal grew up in a small-business family where dinner conversations often centred on working capital and savings. Her early experiences with investing, particularly during the 2008 financial crisis, shaped her approach to understanding markets and evaluating investment opportunities. She began her career at a mutual fund company before moving into investor education and financial writing for asset and wealth management firms. Before joining The Motley Fool, Puja wrote for Market Realist, where she extensively covered the semiconductor industry. Her published work has also appeared in The Indian Express. Puja believes every stock has a story that can help investors understand its potential returns. She combines business analysis with different investing approaches to help investors make informed decisions and align their portfolios with their long-term financial goals. Outside of finance, Puja enjoys long drives, catching up with friends, watching superhero and science-fiction movies, and managing her family portfolio. She also has a keen interest in artificial intelligence and its potential to reshape the world.

Education

Bachelor's degree in Accounting and Finance, University of Mumbai (2007)
CFA Level I

Areas of Expertise

Qualitative company analysis, management strategy, risk assessment, long-term investing, portfolio diversification and rebalancing, dividend reinvestment, cyclical growth opportunities, compounding strategies, growth stocks, and dividend stocks.

Social Media Profiles

Favorite Investment Quote

"Risk comes from not knowing what you're doing." — Warren Buffett

Published October 28, 9:00 pm EDT

Many Canadians don’t use their Tax-Free Savings Account (TFSA) to its full potential because they don’t understand its benefits. A simple test for this is whether you have invested in dividend stocks in a normal brokerage account even when you have TFSA contribution room. Dividends are added to your taxable income, although the dividend tax credit reduces the tax amount. You can save on dividend tax by investing in Canadian dividend stocks through the TFSA.

In the dividend investing strategy, you have to consider four things:

Blocks conceptualizing Canada's Tax Free Savings Account — Source: Getty Images

1. Is the dividend eligible or ineligible?

Eligible dividends are dividends paid from after-tax income. Since that amount is already taxed at the corporate level at 38%, they are eligible for a dividend tax credit (DTC) of 15% at the federal level plus a provincial credit. The status of a dividend being eligible can be found on the company’s dividend page or the tax slip the company will provide. Canadian Natural Resources pays eligible dividends.

Suppose you earn a $100 dividend. You add back the 38% corporate tax by multiplying the amount by 1.38 to arrive at a taxable dividend amount of $138. On this, you calculate federal DTC of $20.7 (15% of $138). If your marginal tax rate is 30%, your tax bill is $41.4 on $138 dividend income. You can deduct $20.7 DTC from $41.4 and pay a reduced tax bill of $20.7.

Eligible dividend amount	$100
Corporate tax rate markup of 38%	1.38
Taxable dividend income	$138
Marginal tax assumed at 30%	$41.40
Federal dividend tax credit at 15%	($20.70)
Final Taxable Amount	$20.70

Note: We have not included the provincial tax credit in this calculation.

This is how your dividends are taxed in a non-registered account. But you can pay $0 tax on dividends by investing through a TFSA.

2. Is the dividend paid by a Canadian company or a US company?

The only exception to the TFSA tax benefit is foreign stocks. While you can invest in US stocks through a TFSA, dividends paid by them are subject to a 15% withholding tax. However, any capital gain on US stocks is tax-free. So while a TFSA is a good account to earn tax-free dividends, it should be from Canadian companies. This earns Canadian Natural Resources two points for TFSA investment.

3. Will the dividend amount grow?

In dividend investing, you have high-yield dividend stocks like Freehold Royalties that give a 6.11% yield. You also have dividend growth stocks like Canadian Natural Resources that grow dividends at an average annual rate of 20% in the long term. TFSA is particularly beneficial for long-term investment in dividend growth stocks, as the dividend amount will grow along with your working income. If you invest through a non-registered account, it will add to your taxable income even when your marginal tax rate is high. TFSA will allow you to withdraw those higher payouts tax-free irrespective of your tax bracket.

4. Are you opting for a dividend reinvestment plan (DRIP)?

Another popular dividend investing strategy is DRIP. In this, you reinvest the dividend amount to buy more shares of the same company. Even though you reinvest the dividend amount, you have to report it as taxable income and pay relevant tax.

Many companies like CT REIT and Manulife Financial offer DRIPs that help you save on brokerage costs. DRIP is an effective tool for compounding. However, dividend tax could dilute the effect as a lower amount is reinvested. TFSA rule states that investments can grow tax-free inside the TFSA. It means that when you invest through a TFSA, no tax is applicable, even if you opt for the DRIP option offered by companies or manually reinvest your dividends.

Ideal dividend stocks for a TFSA

Neither a Registered Retirement Savings Plan nor a non-registered account can give you the tax-free passive income a TFSA can. Canadian Natural Resources is an ideal TFSA stock as it has a 26-year history of growing dividends. However, it is trading near its all-time high as escalating tensions in the Middle East increase oil prices. You could consider buying this stock when oil prices cool.