You Can Earn $50K in tax-free Dividends, but There’s a catch: You can’t have a Job
While early retirement may be a pipe dream for most of us, every once in a while I hear from readers who have pulled it off and are living almost tax-free on dividend income alone. An example is Torontonian Phil McKinley, who retired in his early 40s a couple of years ago and has been living on his non-registered dividend income tax-free.
While McKinley is reluctant to divulge his full financial situation, it’s consistent with a growing body of literature that reveals how it’s possible for Canadian investors to earn up to $50,000 a year in dividend income and pay almost no tax: provided they have no other sources of income.
That’s a big qualifier, of course. By definition, employees do have a rather large other source of income, namely employment income; as do seniors with generous employer pension plans. I’d argue people like McKinley are relatively rare: they have lived frugally and built a stake so that they can get by without employment income, but are too young to receive the usual sources of retirement income.
For those not in these special circumstances, non-registered eligible dividend income will be taxed at the usual rate (combined federal/provincial): In Ontario, roughly 25 per cent or more for those making more than $90,000 a year, rising to a whopping combined rate of 39.34 per cent for those earning more than $220,000.
The question arises: to what extent can retirees or semi-retirees who occupy more modest tax brackets generate tax-free or virtually tax-free dividend income? Note that some strategies — like drawing down RRSPs early — work against this approach. On the other hand, if you’ve opted to defer the Canada Pension Plan and/or Old Age Security till 70 or close to it, that might make the tax-free dividend income strategy partly implementable in semi-retirement.
According to a BMO Financial Group report from last May titled Eligible Dividend Income, at least eight provinces or territories make it possible to receive $51,474 in “tax-free” eligible dividend income, again provided there are no other major sources of income, and notwithstanding any provincial health levies.
These include Alberta, British Columbia, New Brunswick, Ontario, Saskatchewan, the Northwest Territories, Nunavut and Yukon. It’s only $45,309 in Prince Edward Island, $35,835 in Quebec, $30,509 in Nova Scotia, $24,271 in Manitoba and just $18,679 in Newfoundland and Labrador.
Note this data is as of 2016: According to John Waters, Vice-President, Director of Tax Consulting Services for BMO Wealth Management, BMO won’t update for 2017 until all 2017 provincial budgets are released. When it first began publishing the document for the 2012 tax year, the maximum amount of tax-free income on eligible dividends was $47,888 in Ontario and eight other provinces. The amount rose to $48,844 in 2013 and to $49,284 in 2014.
Also note that the amounts in the BMO table reflect the actual amounts of eligible dividends received, before applying the 1.38 “gross-up” factor. So as McKinley says, this equates to $71,034 of dividends in Ontario on a grossed-up basis on which tax does not have to be paid.
This low-tax phenomenon happens through a combination of the Basic Personal Amounts (which in 2016 made the first $11,474 tax-free federally) and the 15.02 per cent federal dividend tax credit on eligible Canadian dividends: once you “gross up” your eligible dividend income by 38 per cent (required when you file your annual taxes), the non-refundable dividend tax credit kicks in, reducing taxes owing. (Your T-5 slip will indicate if the dividend is eligible or non-eligible). There are also provincial dividend tax credits: in Ontario since 2014 it has been 10 per cent of the grossed-up dividend.
Given the right circumstances and planning, the strategy can work, says Aaron Hector, a certified financial planner with Calgary-based Doherty & Bryant Financial Strategies. So for couples in the $51,474 category, that’s potentially $100,000 worth a year of tax-free dividends, assuming each spouse declares 50 per cent of the dividend income on their tax returns. That seems to be the default assumption although it’s possible to adjust the split if you can satisfy the attribution rules and show a disproportionate amount of the non-registered capital came from one spouse or the other. Hector adds that by judicious use of spousal loans, the mix can vary.
Vancouver-based portfolio manager Adrian Mastracci, of Lycos Asset Management, says it’s rare to have the kind of portfolio that could generate $50,000 of dividend income and not also have other kinds of income (notably employment or pension income). He points out that if you can generate an average 4 per cent dividend income, you’d need more than $1 million in non-registered stocks to generate such income.
But to really benefit from all this — even assuming no other large sources of income — you really have to be in the lower tax brackets. According to this site at TaxTips.ca, the tax rate (combined federal/Ontario) on eligible Canadian dividends in 2016 was actually minus 6.86 per cent on the first $41,536 of such income. Between $41,536 and $45,282 the tax rate is minus 1.2 per cent. Waters says that merely shows the power of the dividend tax credit at lower tax rates exceeds the lowest marginal tax rates.
Those tax rates are much less than the capital gains rate of 10.03 per cent and 12.08 per cent in those first two brackets. Between $45,282 and $73,145 the tax rate on eligible Canadian dividends is still a modest 6.39 per cent (compare to 14.83 per cent for capital gains in that bracket, and a whopping 29.65 per cent for interest or other income in that bracket.) From there, the combined tax rate on eligible dividends steadily rises, reaching as high as 39.34 per cent for those making $220,000 or more in Ontario.
Waters agrees that for most people, it’s somewhat unrealistic to have zero income other than dividends, although it can come up if children are the beneficiaries of a trust that flows out eligible dividends, for example (being mindful of income attribution rules). Still, the key takeaway is that the dividend tax credit can provide very low effective tax rates for individuals in the lower marginal tax brackets.
The rest of us should scrutinize the tax brackets and tax treatment of investment income in each of those brackets and try to optimize it all. Of course, Ottawa is always changing the rules in midstream so it’s hard to plan too far ahead. While it largely stood pat in the recent federal budget, its moves to address “tax fairness” may have impacts later this year.
Jonathan Chevreau is founder of the Financial Independence Hub and co-author of Victory Lap Retirement. He can be reached at firstname.lastname@example.org