For retired Canadians, losing 15 cents of Old Age Security (OAS) for every dollar of taxable income can be a pain point. Clients with portfolios of dividend-paying Canadian stocks may have heard that earning interest income instead would reduce the OAS clawback. But does this make sense?
The OAS clawback is based on the taxable income reported on Line 234 of the T1 general tax return. If this income is above $77,580 (in 2019), then OAS begins to be reduced. Once this income reaches $125,696, OAS is fully clawed back. Maintaining full OAS means reducing Line 234 income.
Interest income is reported as taxable income on a dollar-for-dollar basis, while eligible dividends are subject to a gross-up of 138%; clients who received $1 of eligible dividends report $1.38 of taxable income. Therefore, the higher reported income for dividends would result in more OAS pension being returned to the government.
The reporting of a higher taxable income from dividends rather than interest also has the following potential negative impacts:
- higher income taxes before any tax credits are accounted for;
- lower income-sensitive credit amounts, like the age amount; and
- potentially higher income-sensitive taxes or fees, like provincial surtaxes and other provincial levies.
But wait, you say. Aren’t dividends more tax efficient than interest?
They are, because of the dividend tax credit. Despite the higher income taxes on dividends initially, the net result is a lower tax liability and rate than on interest, all else being equal.
So, we have a conundrum: dividends are more tax efficient than interest but result in a higher OAS clawback.
Despite this, receiving dividends may still be better than interest from an after-tax income perspective. Why? The benefit of the dividend tax credit may outweigh the costs listed above.
Rachel, a fictitious 72-year-old, receives maximum OAS, CPP and some eligible pension income. Her total from these sources is $77,580. She has a portfolio of stocks in a taxable account that pays her $10,000 of eligible dividends annually. Since she must report $13,800 as taxable dividend income, her total income on Line 234 is $91,380.
Rachel is starting to have second thoughts about this stock portfolio and the dividend income it generates due to her annual OAS clawback. She wonders if she would’ve been better off receiving $10,000 of interest income instead. Does the dividend tax credit offset the costs associated with the dividends’ higher reported income?
Table 1 captures the dividend tax credit (federal and provincial combined), the incremental tax costs associated with the dividend’s higher reported income (higher taxes before credit, lower age amount, higher provincial surtaxes and fees where applicable) and the incremental increase in the OAS clawback associated with Rachel’s dividend income.
As you can see, regardless of where Rachel lives, the benefit of the dividend tax credit outweighs its associated costs, including the higher OAS clawback. Of course, if Rachel’s income mix were different (e.g., employment income, net rental income) her available deductions and credits may be, too, and this cost-benefit analysis would need to be reviewed.
Dividends and interest are not the only sources of income or cash flow clients can receive from investments. If you’re looking to lower a client’s reported income from taxable investments on Line 234, consider the following:
- With realized capital gains, only 50% of the gain is reported as taxable income.
- With return of capital, none of the funds that can be received from investments such as real estate investment trusts and mutual funds is reported as taxable income. When the adjusted cost base of such investments reaches $0, distributions will be treated as taxable capital gains.
- TFSA withdrawals, like return of capital, are not reported as taxable income.
Revisiting clients’ income sources and portfolios could be the first step toward reducing taxable income and avoiding the dreaded OAS clawback. However, don’t lose sight of the bigger picture by fixating on one cost in isolation. Evaluate the entire tax situation to see the overall benefit or cost to your client.
|Dividend tax credit||$3,729||$3,453||$3,591||$3,177||$3,453||$3,699||$4,005||$3,294||$3,522||$2,818||$3,732||$3,660||$2,833|
|Net benefit (cost)||$2,120||$1,860||$1,917||$1,345||$1,792||$1,488||$2,202||$1,485||$1,713||$1,038||$2,155||$2,112||$1,318|
Curtis Davis, FMA, CIM, RRC, CFP, is senior consultant, Tax, Retirement & Estate Planning Services, Retail Markets at Manulife.