Borrowing to Invest in Dividend StocksPosted: July 29, 2012
In Canada, the CRA allows one to deduct interest expenses (Line 221 in the 2011 tax return) used for income producing investments from their net income, which results in lower taxes paid by an individual in any given tax year. I was curious as to whether or not borrowing to invest in dividend paying stocks would result in more income after taxes. To investigate this, I created a spreadsheet model to test a number of scenarios. The results I found were pretty interesting, and are summarized below:
|Scenario 1||Scenario 2||Scenario 3|
|Employment Credit Amount||$1065.00||$1065.00||$1065.00|
|Ontario Health Premium||$750.00||$750.00||$750.00|
|Loan for Investing||$0.00||$10,000.00||$10,000.00|
|Loan Annual Interest Rate||n/a||4.25%||4.25%|
|Income After Taxes||$72,695.44||$72,952.37||$73,040.15|
Some notes about the above. First, to keep things simple I used employment income of $100,000. I wish I made that much, but it makes things simpler for the model. $100,000 net income simplified the Ontario Health Premium, which was $750.00. I also assumed the maximum for CPP and EI. All of these numbers are based on the 2011 tax year for the Province of Ontario. And as one final check, I punched the same numbers into the Canadian Income Tax calculator found at Tax Tips and came up with identical results.
So, what do those results tell us? Scenario 1 is the control scenario, where we don’t borrow and don’t receive dividends. In that scenario, an individual pays out $27,304.56 in income taxes for the given year. Scenario 3 was a more realistic scenario: borrowing to invest in a company whose dividends were higher than the borrowing interest rate. Thanks to the tax credits one receives on dividend income, and the fact that interest income is deducted from your net employment income, the total taxes paid were less than in Scenario 1 by $64.71. What was surprising Scenario 2: borrowing to invest, and then purchasing shares in a dividend paying corporation with a dividend yield identical to the interest rate on the loan, yielded less overall taxes than Scenario 1 by $82.68! This means that borrowing to receive dividends where the net gain between interest payments and dividend income is $0.00 still yields lower taxes.
Of course, there are a couple of caveats to this approach. First off, when you borrow, you have to pay off the principal as well. However, if you are borrowing to invest in quality companies, then in theory the company’s share price should increase, so over time you could unload your position to pay back the principal of the loan. Also, most loans require you to pay both interest and principal. CRA rules only allow you to deduct the interest payments, not the principal payments; this means that your net income before taxes would be lower than in the model here, which assumes that you never pay down the principal. Finally, when you do go to sell the position, you will be hit by a capital gains tax.
Given the caveats, one, the extra cash in hand is less than $100 (which is less than 0.1% of $100,000 net income), two, the extra work involved, and three, the risks of the company’s share price dropping, this strategy may not be worth it. However, it was still an interesting exercise; no matter which way you cut it, you are still technically better off since you end up with more cash in pocket at the end of the day.