Dividends are a great way to build passive income for a few reasons, one of which is the preferential tax treatment they get. Just knowing they enjoy this benefit is enough for some people, but others like to dig into how things work. If you’re a bit of a tax nerd, this post is for you!

Remember that a dividend is a portion of the earnings of a corporation that it pays to its shareholders. Corporations have already paid tax on the earnings they distribute as dividends so governments in Canada and the U.S. give shareholders a tax break on dividend income to avoid it being taxed twice. In Canada, dividends are grossed-up and qualify for a tax credit to “credit” you for the tax already paid by the company. In the U.S., dividends are taxed at a considerably lower rate than regular income to reflect the tax already paid by the corporation.

Here’s how it works in Canada. You have to convert the amount of your dividend to what it was worth before the corporation paid tax on it. This is done by grossing it up by 38% (i.e., multiplying it by 1.38). Next, you figure out how much tax you would expect to pay on that grossed-up amount, based on your marginal tax rate. Last, you subtract the dividend tax credit, which represents the tax already paid by the corporation. The net result is the tax you actually have to pay. For 2015, the federal tax credit in Canada is 15.02% of your taxable amount of dividends while the provincial credits vary by province (find them here). Note that we’re only discussing “eligible dividends;” that is, those paid by public corporations in Canada.

Let’s look at an example for Josh, who lives in Ontario. In 2015, Josh received $3,500 in eligible dividends. His grossed up amount is 3,500 x 1.38 = $4,830. Josh has to report this amount on Line 120 of his tax return. Because of Josh’s employment income, his dividends are taxed at the 22% marginal rate and his provincial tax rate in Ontario is 9.15%. Josh’s federal and provincial tax payable would be $1,062.60 and $441.95, respectively, for a total of $1,504.55. Now he subtracts his federal tax credit of $725.47 (4830 x 15.02%) and his provincial credit of $483 (4830 x 10% – the Ontario rate) to find his actual tax liability is only $296.08. This is an effective rate of 8.4%!!! (296/3500)

The math looks like this:

In the U.S. the situation is a little different in that there is a period of time (called the holding period) that you must own the stock before you have to pay tax on dividends you receive. Because we tend to hold shares for the long term we’ll ignore this restriction. Other than that, the calculation is actually easier than is the case in Canada. Dividends are tax-free for amounts in the 10% and 15% brackets, taxed at 15% for those in the 25% up to 35% tax brackets and taxed at a 20% rate for people above the 35% tax bracket.

Here’s an example: Rebecca’s salary puts her in the 25% tax bracket and she collected $4300 in dividends in 2015. While her other income is taxed at 25%, her dividends would be taxed at only 15%.

I should point out that if your shares are held inside a tax-free investment vehicle (like a RSP or TFSA in Canada or an IRA in the U.S.) the tax-preferred status is irrelevant because your dividends are sheltered from tax anyway. The bottom line is that dividends enjoy preferential tax treatment and paying less tax is a great way to build wealth!