This is a part of the Investing Series.
The following information on taxes only applies to Canadians, and specifically in the province of Ontario (where I reside), which judging by this image, is where most people (and the richest of all) live:
This could potentially end up being an awesome strategy for you AS WELL, but I am not going to do tax posts on every single province and/or state.
You’re going to be on your own for that, unless I get swarmed with millions of emails for one specific state.
(Don’t swarm me with emails please.
Sorry, I don’t know what an email address is, so you can’t contact me.
What about that contact GMAIL button at the top of my page?.. Oh. That? That little button?
It doesn’t work for emails regarding tax implications for dividends where you live, unless you live in Ontario, Canada.)
I know what you’re thinking:
She has saved the juiciest part of investing for .. what, a month after she started this series!?
BRING IT ON!
How can I NOT PAY so much tax!??
It’s because it involves work, namely dividend investing.
And dividend-investing as a strategy still may not be for all investors who aren’t interested in this stuff (totally fine and understandable, I wasn’t either until I started PF blogging).
I keep repeating this, because I want you to REALLY understand the following:
Index fund investing is passive, easy, and you will pretty much preserve your wealth over a long period of time without doing a lot of work.
If this sounds like a great deal, go into index fund investing as your strategy. It takes less savings up front, and the results are when you retire.
Dividend income investing, is NOT passive. It is NOT as easy. It takes WORK. It takes RESEARCH. It takes READING.
Takes sucking out hours of your week and before you realize it you’ve been hunched over a laptop, squinting at all of the company’s financials for the past 4 hours, and reading on why it sucks as a company or rocks as a company.
It also takes a LOT of saving up front before you see any significant results.
Now. Let’s talk about how you can make about $50,000 a year living in Ontario off dividend income and pay $0 in taxes.
The following takes 2 things into consideration:
- Assuming this is your ONLY income (obviously if you earn a wage, you will need to pay taxes on it)
- Assuming you live in Ontario, Canada (oh, you didn’t get that by my many disclaimers above? :P)
Now let’s start with some basic tax information.
DIVIDEND TAX CREDITS (DTC)
Companies pay out dividends, but before they do that and re-distribute your capital back to you, they have to pay taxes on their earnings.
This is where DTCs come in. They are tax credits passed on to shareholders who take dividends from companies, because it isn’t fair to charge you TWICE in taxes.
This tax credit ONLY applies to the following types of companies in Canada:
- Publicly traded corporations resident in Canada
- Other Canada-resident corporations who pay the corporate tax rate on their earned income
- It does NOT apply to foreign corporations that are not residing in Canada, like Starbucks (SBUX), who pay dividends; so you should think about investing in dividends from Canada as a Canadian
So basically, any company in Canada that is publicly traded as a stock on the stock market.
There’s a complicated (kind of ridiculous) little system to figure all of this out, but follow along!
STEP 1: FIND THE DIVIDEND GROSS UP
This gross up is exactly as how it sounds. Gross.
You have to multiply the eligible dividends you are receiving, by a factor, and that’s called the ‘dividend gross-up’, and it basically reverts back the money you received into the gross income the company paid before.
In 2012 it is 38%.
(You should be using: Canada Revenue Agency Form T3SCH8 – Investment Income)
Let’s say you got $50,000 in dividends a year.
$50,000 x 1.38 = $69,000
This is the “gross-up amount” of eligible dividends.
This means that the company you got your dividends from, earned about $69,000 as a gross income before taxes to be able to give you that $50,000 in net dividend income.
Making sense so far?
STEP 2: NOW FIGURE OUT YOUR FEDERAL AND PROVINCIAL DIVIDEND TAX CREDITS
If you are unsure on how tiered taxes work (also known as ‘marginal tax rates’, read: Doing your taxes – Myths, Reality Checks, Earning More Money and How Soon to Send Them
It will be as if you are being taxed on earning that $69,000 gross, as we did the dividend tax reversal or ‘gross-up’.
As we all know, we have 2 tax levels: Federal (Canada) and Provincial (Ontario).
The Federal Tax Credit is 15.02%
The Ontario Tax Credit is: 6.4% (lowest of all the provinces, since 2010)
You can check out the table of dividend tax credits for Canada here.
$69,000 x 15.02% = $10,363.80 in Federal Tax Credits
$6900 x 6.4% = $4416 in Ontario Tax Credits
Total Dividend Tax Credits = $14,779.80
STEP 3: NOW FIGURE OUT WHAT YOU’D NORMALLY PAY IN TAXES AND APPLY THE CREDIT
On an income of $69,000 you’d normally pay about: $14,952 in taxes give or take as an Ontario resident.
Your tax credits of $14,779.80 in tax CREDITS, would pretty much leave you paying less than a thousand:
$14,952 – $14,779.80 = $172.20 in taxes for 2012
You’d end up only paying $172.20 in taxes, on $50,000 of income.
WAIT, WHERE IS THAT NO TAX DEAL YOU PROMISED ME?
$50,000 was just an easy, simple number to use so you could see how it works.
What it really means, is that you should earn about $47,888 in dividends before you pay absolutely bupkiss in taxes.
A big, fat, delicious tax bill of $0.
(Source: Globe & Mail – BMO for the exact amount)
HOWEVER, THERE IS A CATCH.. AS THERE ALWAYS IS..
To get that $47,888 in dividend income so that you can avoid paying any taxes at all, you need to save a little over a million dollars.
(Assuming you get a 5% return of dividends on your income, you need a capital of $957,760 saved.)
And how might one save such a capital?
It always comes back to the same old story:
- Live on less
- Budget and Track your Expenses
- Save as much as you can
So there you have it.
Amass $957,760 in capital, get at least 5% back in dividends each year by spending 10-20 hours a week reading financials and watching stocks, and you could pay $0 in taxes in Ontario.
MY PLAN FOR USING THIS TO MY ADVANTAGE
I only need about $30,000 to live fairly comfortably, so my plan is to think about getting a personal dividend stock portfolio paying out an average of 5% in dividends, which means I need to save about $600,000 to reach that goal.
This is part of my strategy, and the rest is to put my money to grow in index funds.
It’s not to say I don’t find this strategy attractive (I do!), but I don’t like putting all my eggs into one basket.
A mix of index fund investing and dividend-paying stocks (even though it takes a lot of time and research), is my investing strategy going forward.
Index fund investing is still attractive to me, because I can throw it in my retirement savings funds (tax-sheltered), and I will only withdraw it if I need to when I go to retire.
It grows tax-free. How can you not love that!?
Like a backup plan for in case my dividends get significantly cut one year (very possible with stocks!), or if something goes wrong.