Dividends to boost your portfolio

Building investments for a tax-effective income stream

Investors who want a steady flow of tax-effective income often look to dividend-paying stocks to fill out their portfolio. Since dividends are paid from profits, companies must keep making money to maintain, and hopefully increase, their payouts. Structured properly, a portfolio that builds in dividend-paying investments can boost income now and deliver better investment performance over time. 

The case for dividends

Dividends are a payout of a company's profit and cash flow to its investors. When you invest in a successful business, the dividends it pays can become a reasonably reliable income source for years, even decades.

Preferred tax treatment. What catches most people's attention around dividends are the tax benefits. Dividend investments offer a tax advantage over other investments such as bonds^† and term deposits. When held outside of a registered plan, eligible dividends – generally those from Canadian public companies – can benefit from the Dividend Tax Credit. With the credit, dividend income attracts far less tax than interest income does.

More (and more) income. Bonds may offer a predictable return, but that return is also guaranteed not to grow over the life of the investment. Dividends, on the other hand, have the potential to rise, and in some cases, quite dramatically.

Higher, more stable returns over time. Studies have shown that share prices of companies that make, and better yet increase, their dividend payments have outperformed the broader market indexes with less volatility and trumped dividend non-payers.

Ignoring dividend stocks in favour of the market's high-fliers or the latest hot sector can significantly cut into your portfolio's performance over the longer term.

Finding dividend income

If you want dividends, they aren’t hard to find. Investing directly in the equity of dividend-paying companies is one way. Common shares and preferred shares are some potential sources of dividend income. If you go the direct route, it's important to invest enough capital to be properly diversified.

For many investors a better choice might be mutual funds^† or exchange-traded funds^† which offer diversification and professional management for a smaller investment. There are plenty of options. Choose products with exposure to the broad equity^† market or vehicles holding only dividend payers, growers, or preferred shares for example.

Each approach offers advantages and disadvantages around management, trading costs and convenience, so ask your advisor to help you review the trade-offs.

Whichever tack you take, "averaging in" to the market with a series of smaller, regular investments can be a smart way to reduce risk. This strategy will lessen the odds that you'll load up at the top of the market and you’ll potentially reduce your average investment cost over time, enhancing your returns.

Working dividend-paying investments into your portfolio

How far should you go to work dividend-paying investments into your portfolio? The answer will depend not only on your income needs and growth objectives, but on your risk tolerance as well.

Dividend-paying investments aren't guaranteed and can be more volatile than fixed income choices. They can supplement, but probably shouldn't replace, your core fixed rate investments.

Make sure you’re diversified

Concentrating on dividend payers can overload your portfolio with the "slow and steady" like utilities and phone companies. The problem? It can leave you underweight in more cyclical sectors like energy and materials, which tend to outperform when economic activity picks up. Review your equity portfolio in its entirety, making sure you have enough diversification to meet your risk tolerance and goals.

Having a good variety of dividend-paying securities will help protect you from a particular company or sector hitting hard times. But creating a healthy roster of strong dividend payers across a wide range of sectors isn't easy to do if you limit your search to companies here at home.

Consider adding at least a few U.S. and foreign dividend-paying stocks to your holdings. They'll provide added diversification across industries and help hedge your portfolio and investment income against declines in the Canadian dollar.

Dividend funds

Another option to take advantage of the benefits of dividends is to invest in dividend funds. Different dividend funds^† have different mandates, even though the standardized investment fund classifications lump them all together.

Basically, there are two broad types: dividend growth funds and dividend income funds.

Dividend growth funds tend to invest in common stocks with good records for paying dividends. These funds are aimed at investors who hope to benefit from capital gains as those stocks appreciate. In the meantime, they receive their share of the dividends the fund collects on its holdings.

Common share dividends are variable. They often rise when companies do well, but it is possible they might be reduced or even suspended, depending on business conditions.

A dividend growth fund is likely to produce more capital gains, both from the fund's trading and when you redeem units. Capital gains dividends are taxed more favourably than interest income.

Dividend income funds put a greater emphasis on providing steady income than on generating capital gains. While they may hold dividend-paying common shares, they also favour preferred shares and income or royalty trusts with more stable cash flows.

Dividend income funds that hold income trusts may also offer tax-effective distributions. Income trusts often generate payments in the form of tax-deferred return of capital and may "flow through" the tax benefits available to the businesses in which they invest.

The joy of reinvesting

If you don't need much income or have a long investment time horizon, look for options that let you reinvest your dividends. The compounding effect from reinvesting dividends can make a huge difference to how much you'll have in the end.

Structure for tax savings

You shouldn't let tax concerns be the only driver for your investment decisions, but how well you organize your dividend paying assets for tax-efficiency can boost, or hold back, your returns over time.

Recall that a major tax benefit of investing in Canadian companies is the Dividend Tax Credit. However, you can only capitalize on this incentive if your dividend payers are held in a non-registered account and not in a TFSA, RRSP or RRIF.

Foreign dividends are another matter. They're taxed at full marginal rates. Also look out for withholding taxes levied by the company's home government. Canadian investors can, in many cases, offset the withheld income tax by claiming the foreign tax credit if those foreign companies are held outside of a registered plan.

Note that because of the U.S.-Canada tax treaty, dividend income from American companies isn't subject to those same withholding taxes if held in an RRSP or RRIF.

Structuring your dividend income for tax-efficiency especially when foreign income is involved can get complicated. Get professional guidance to make the proper decisions.

In the short run, it's difficult - if not impossible - to know which investments will do best. Dividend-paying investments might not be a sure-fire path to riches, but over the years it's been a proven strategy for delivering growth and income to investors.

It doesn't matter if you're looking to beat low interest rates and produce more investment income or grow your nest egg for the future. Dividend-paying investments can make a difference. Contact your BlueShore Financial advisor to learn more.