Are you sure you want dividends?

Canadians love their dividends, and who can blame them? Having money land in your investment account feels like free money. Dividends get a lot of attention in the personal finance realm online, with people touting them as a reliable source of income without having to dip into their capital.

For some people, the idea of living off dividends is a dream. While this seems like an amazing feat, investing to generate dividends isn’t all it’s cracked up to be. As the saying in finance goes, “There’s no such thing as a free lunch.” Everything comes with a cost, and dividends are no exception.

What, exactly, is a dividend?

A dividend is a cash payment a company makes to its shareholders. For many companies, the best use of the cash they earn is to re-invest in the business – perhaps to open more stores, hire more people, or develop new products. But some businesses just don’t have these growth opportunities. Instead of leaving the cash in their bank account, they give it to shareholders, who probably have a better use for it.

Companies don’t pay a dividend solely because they have extra cash; dividends have become important for stock prices, especially in industries such as banking, utilities, and pipelines. Increasing the dividend every year helps keep the stock price high, and this can influence a company’s decision to pay a dividend

What to like about dividends

The best thing about dividends is that they are paid to you no matter what the stock market is doing. A dividend payment has nothing to do with whether the price of a company’s stock goes up or down. During the Global Financial Crisis, Canadian bank stocks fell dramatically– in 2008, RBC fell by 44%, TD by 35%, and BMO by 60%. Still, the dividends kept on rolling. Not one of the big Canadian banks stopped paying the dividend or even reduced it. There are cases in which dividends get cut, such as when a company is in financial trouble and no longer has enough cash to pay the dividend. In these cases, a declining stock price can be a warning sign. But this is quite uncommon. Generally speaking, dividends are reliable.

Tax is another reason to like dividends. Dividends paid by Canadian companies are subject to the dividend tax credit. This slightly cumbersome calculation means that for most people, they will pay less tax on Canadian dividends than on any other type of income. Less than employment income, less than interest income, and less than capital gains. This is truly an advantage, especially for people with low taxable income. Of course, this doesn’t matter if you hold dividend-paying investments in an RRSP, TFSA, FHSA, RDSP or RESP – all income in these accounts is treated the same. Income earned in the TFSA and FHSA will never be taxed, while all income in an RRSP, RESP and RDSP is taxed equally – there is no differentiation between the different types.

Lastly, earning income from dividends is easy. The money simply lands in your investment account and is there for you to spend. And who doesn’t like that?

The cost of generating dividends

Now to rain on the parade. There are three primary downsides to generating a lot of dividend income in your investment account.

The first is a lack of diversification. If you want to earn income from dividends, you have to own a lot of Canadian stocks. Not only that, you will own stocks that are concentrated in just a few sectors: banks, utilities, pipelines, and telecoms. Companies in other sectors also pay dividends, but the payout is lower than that of the dividend superstar sectors.

Let’s say you have $500,000 in your non-registered (fully taxable) investment account. If you put all of it in a high-dividend-paying ETF, you could generate about $23,000 a year in income. That’s not nothing, but it’s not enough to live on. And if you did go for this option, you’re going to be grossly under-diversified, as you’ll have little to no exposure to companies in the technology, healthcare and consumer sectors. This is detrimental to your returns because some companies in these sectors are high-growth businesses that experience a lot of stock price appreciation. Yes, they pay little to no dividends, and that’s because they have lots of profitable things to do with the money, namely, growing their business. Apple will expand their production and develop new products, Dollarama will open new stores, and Amazon will continue to invest in faster shipping.

The second downside of dividends is this: you might think you want all of that income, but do you actually need it? There may be years when this extra income is more than you need. If you are heavily invested in dividend-paying stocks, that income will come whether you want it or not. This means you’ll be generating taxable income for no good reason, when instead you could be deferring the tax by investing in higher-growth companies that give you capital gains with their rising stock prices. And remember, capital gains are not taxable until you sell the investment, and deferring tax as long as possible is usually a big advantage.

And if all of that hasn’t made you think twice about dividends, consider the fact that the tax rate you pay on dividends goes up as your income goes up. In fact, there comes a point at which the tax you pay on dividends is higher than the tax you pay on capital gains. For example, if you live in Ontario, the tax rate on dividends becomes higher than on capital gains when you have about $120,000 of taxable income. In BC, it’s more like $180,000, while in Quebec it’s about $110,000. Generating dividends in a taxable account is really beneficial for lower-income folks. Under $55,000, you pay zero tax on these dividends if you live in Ontario.

The Bottom Line

Many decisions in financial planning are not just financial decisions. They are also emotional. While making the right economic decision will result in more wealth, the right emotional decision will make you happier. There’s no point in making the right economic decision if it means you will lay awake at night worrying about money, and check your bank account with anxiety every day. For instance, paying down a mortgage is usually the wrong economic decision, but many people feel more secure with less debt. Investing too conservatively rather than going all-in on the stock market is going to result in lower returns and lower wealth over the long run, but it will make some people feel calmer in turbulent markets. Investing for dividends is the same. For most people, dividend investing doesn’t make economic sense, but it sure does make emotional sense. Even I - with my nearly 30 years of investing experience and the data to make the right economic decisions - make choices that feel better. I paid down my mortgage before I had to, and I invest to generate dividends in my TFSA for our “fun money”. (I have always been 100% invested in the stock market in my RRSP, though.)

Make the decision that balances the economic and emotional factors. Just be careful not to be a victim of fear, which can cause you to be so overly conservative that you sacrifice a more abundant future