One of the nice things about dividends is that they're taxed at a lower rate than interest or other income.

Most people know that. What they may not know is that, depending on the province, it's possible for an individual with no other sources of income to earn nearly $50,000 in dividends without paying any tax at all.

How? Two words: tax credits. Specifically, the dividend tax credit and the basic personal amount available to all Canadians.

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Today, we'll walk you through a sample calculation that illustrates how these two credits work together to make dividends such an attractive choice. First, let's brush up on the dividend tax credit, whose purpose is not well understood by many investors.

Explaining the DTC

When you receive a dividend, the money is paid out of the after-tax profits of the corporation. Because the company has already paid some tax, it wouldn't be fair to ding the shareholder in full a second time, right?

So the taxman came up with an ingenious – albeit confusing – solution: The gross-up and tax credit system. The purpose of this system is to give you "credit" for the tax the corporation has already paid.

Here's how it works. On your tax return, you are required to gross-up the dividend (for 2012 you would multiply it by 1.38). In effect, what you're doing is converting your dividend (on which corporate tax was already paid) back to an approximate amount of pretax corporate earnings.

The next step is to figure out how much tax you would theoretically pay on that grossed-up amount, based on your marginal rate. Finally, you would subtract the dividend tax credit, which is intended to compensate you for the tax already paid at the corporate level. The net result is what you would actually pay in tax.

For 2012, the federal dividend tax credit is 15.02 per cent of the grossed-up dividend; provinces also chip in their own dividend tax credits, ranging from 6.4 per cent in Ontario to 12 per cent in New Brunswick, according to Taxtips.ca.

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Putting it together

Confused yet? Let's look at an example of the dividend tax credit in action and you'll see how everything comes together. We'd like to thank John Waters, head of tax and estate planning at BMO Nesbitt Burns, for providing the detailed calculations that follow.

Let's say you live in Ontario and, after years of diligently investing, you have amassed a dividend portfolio worth $1.2-million. Let's further assume your portfolio generates $47,888 in eligible Canadian dividend income, which works out to a yield of about 4 per cent, and that you have no other sources of income.

Your grossed-up dividend income would be $47,888 multiplied by 1.38, or about $66,085. This is the amount of income you would report on your return.

That sounds like a raw deal. Who wants to report more income than they actually made? But if you refer to the accompanying table, you'll see how this income results in a final tax bill of zero. The total federal tax of $11,549 (calculated at progressive marginal rates of 15 per cent and 22 per cent on the grossed-up dividend income of $66,085), is offset, to the dollar, by the basic personal tax credit and by the federal dividend tax credit.

Also note that, at income levels below $10,882, you're actually getting two credits working for you – the dividend tax credit and the basic personal credit. This one-two punch is what makes dividends so tax-effective, Mr. Waters said.

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It's a similar story for Ontario tax. The basic personal credit and provincial dividend tax credit together amount to $4,704, which is actually more than the $4,447 in Ontario tax. Unfortunately these are non-refundable credits so you don't get any money back. You'd still have to pay $600 for the Ontario Health Premium, but that's a drop in the bucket.

What about other provinces? According to Mr. Waters, the amount of tax-free dividends ranges from $23,447 in Manitoba to $47,888 in other provinces including Ontario, Alberta, Saskatchewan, British Columbia and the three territories.

A taxpayer qualifying for other credits, such as the spousal, child or age amounts, might be able to earn even more dividend income tax free, he said.

This example is for illustrative purposes only, and Mr. Waters recommends consulting a tax professional to confirm the implications of your own situation.

It's also worth noting that, for all its advantages, the gross-up and dividend tax credit system is decried by some seniors because it creates "phantom" taxable income that can cut into government benefits.

Notwithstanding those concerns, the favourable taxation of dividends is a powerful reason to consider dividend stocks for your own portfolio.

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Assume an Ontario resident individual earns $47,888 in eligible dividend income. Multiplied by the gross-up of 1.38, taxable income would be $66,085.