Tag Archives: tax

Ever Wish You Had More Money?

“If only I had more money…” Ever heard yourself utter those words? If you only had more money you’d… Travel more? Save more for the kids’ education? Invest more? The trouble is, most of us can’t just demand a raise every time we want more money. Well, what if I told you there is a way you could make more money without asking for a raise and didn’t require getting a second job? Would you be interested?

Let’s do some math. Let’s say you live in Ontario and your taxable income is $60,000. That would make your marginal tax rate (the amount of tax you would pay on an additional dollar of income) 31%. That means you would need to earn an extra $1.45 for each additional $1 you want to take home (1.45 x 31% = 0.45). Now let’s turn that around. If you could save $1 it would be like earning an extra $1.45! Get it? You buy things with after-tax dollars which means if you buy something for $100, you had to earn $145 in order to make that purchase. If you can buy things on sale, it’s like earning more money. When you consider your marginal tax rate, it makes waiting for a sale price really appealing. Of course we all know you have more money in your pocket when you spend less, but we rarely stop to consider how much we actually had to earn in order to have that money in our pockets. When you do, it makes your money seem much more valuable.

Now let’s really make things interesting. Let’s see what happens if you take the money you saved and invest it in a tax-sheltered vehicle such as a RRSP. Like lots of men, I love a big screen TV. Basically, the bigger the better. If I’m considering a new TV that retails for $1000 but I wait for a 20% off sale, I save $200. Remember, I had to earn $1630 in order to spend $1000 in after-tax dollars (my marginal rate is 38.5%). The $200 I save during the 20% off sale represents $325 in additional earning.

Ok. If I then invest that $200 in my RRSP, I save $77 in income tax. In other words, I save $200 on the TV but the government gives me a tax refund of $77 which means my actual savings on the TV is $277 and the $200 contribution really only costs me $123! Oh yeah, and that $200 will continue to grow tax-free! Let’s not forget I also have a new TV! If you commit to saving 20% – or more – on everything you buy, it’s not hard to see how it can be an important pillar in your retirement strategy.

The Scoop on Dividend Taxes

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!

dividends_taxRemember 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:

Dividends $3,500.00 (A)
Grossed up amount (A x 1.38) $4,830.00 (B)
Federal tax (B x 0.22) $1,062.60 (D)
Provincial tax (B x 0.0915) $441.95 (E)
Federal dividend tax credit (B x 0.1502) $725.47 (F)
Provincial dividend tax credit (B x 0.10) $483.00 (G)
Tax payable (D + E – F – G) $296.08

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!

Recent Posts