Companies can do several things with their profits, they can fuel further growth by reinvesting in the business or they can give money back to the shareholders through stock buyback programs or dividend payments. Frequency of the dividend payments depends on the company, could be annually, semi-annually, quarterly, or monthly. If a company wants to be able to continually provide dividends to its shareholders year after year, it needs to earn more than it pays out. This brings us to a metric called the Payout Ratio which is simply the Dividends per Share (DPS) divided by the Earnings per Share (EPS). With a good history and a low payout ratio, you can be fairly confident that the company will be able to provide a constant, or even growing, stream of dividends for years to come.
Stock prices fluctuate all the time and do not necessarily reflect how well the business is truly doing. Should you hold onto it for a few extra months and wait for the share price to appreciate? Or maybe it'll go the other way. But dividends are always positive cash flows in your account.
Another great thing about dividends is that they are taxed less than other income sources such as a full-time job or interest on savings. As of 2014 in Alberta, with only tax credits for the basic personal amount and eligible dividends, you could earn up to $49,283 without paying a single cent of federal or provincial taxes. That's equivalent to a full-time job earning a gross salary of $62,630! You could earn even more in dividend income without paying any tax if you qualify for other tax credits such as for age, spouse, or dependents.
So in summary, I invest in dividend paying stocks to earn a tax efficient and reliable source of income for the rest of my life. With a variety of stocks that pay dividends at different times of the year, I can replicate the paycheque frequency of a regular job.
Great post, just curious though, how exactly do we come to the $49,283 amount in Alberta?
ReplyDeleteThanks Abhishek.
DeleteWith an income of $49,283.90 in eligible dividends, the taxable amount (grossed up, 138%) is $68,011.78.
The federal tax credit for this dividend income (15% of taxable amount) is $10,215.23 plus the credit for basic personal amount ($11138 * 15% = $1,670.70) totals $11,885.93. This tax credit completely cancels out the federal taxes owed of ($68,011.78 - $43,953) * 22% + $6,593 = $11,885.93.
The provincial tax credit (10% of taxable amount) is $6,801.18 which is exactly equal to the provincial taxes owed (also 10% of taxable amount). So you will have non-refundable provincial tax credits left over of $17787 * 10% = $1,778.70 for basic personal amount.