By now, you have come across tens and tens, and heck maybe even one hundred sites that are dedicated to dividend investing. You have dissected the reports, seen figures that members are posting in the community, what stocks are being purchased & by whom, as well as in what dollar amounts & frequencies. If you’ve been to our website, then you have seen those items and have seen us post our income results each month and where we stand in our journey to financial freedom with the main catalyst of dividend investing. Instead of being “this thing” that investors and the community is doing, I wanted to pull a major, not the only, but a major driver from behind the curtain on the “why” we are dividend investing. To break it down in one painfully wonderful word, taxes.
The one major word to dividend investing is taxes. As stated earlier, I wanted to really explain another major reason why Bert & I are dividend investing and why you see SO many individuals doing the same (check out our blog roll and monthly dividend income articles from the blogging community to see those individuals). Instead of going down the rigorous path of overly describing the artistic touch of taxes, I wanted to explain in a much more, unsophisticated manner – and will start with the illustrious average salary in America. The most recent date points to just a tad over $48,000; for a very simplistic purpose of this article, we will use $50,000 salary income versus $50,000 of dividend income to show the powerful value of dividend investing.
Now you see, I have to be semi-technical in order to have the appropriate scenery when reviewing this production of what some may call… “magic”. I will summarize the technical verbiage in 4 bullet points to help satisfy the pain of bringing in these mechanical terms:
1.) Most state & local income taxes are not impacted by dividends, i.e. you do not pay state/local income tax on qualified dividend earnings.. directly. State income tax is typically derived based on your AGI within your federal income tax form, which you will see below.
2.) There are no Medicare or Social Security taxes on Qualified dividend earnings, only on wage income or self-employment income
3.) The federal tax brackets for 2017 can be found here, but in short, the ranges are (single individuals) $0 to $9,325 (0%), $9,325 to $37,950 (15%), $37,950 to $91,900 (25%), $91,000 to $191,650 (28%), $191,650 to $416,700 (33%), $416,700 to $418,400 (35%), $418,400+ (39.60%)
4.) We will stick with singe tax-filer in our scenario here
Alright, did I bore you guys yet with those 4 bullet points? Not ready to leave the classroom, right? How about I put a funny picture of Bert to entertain you guys, see bottom of the article for that, hopefully that keeps you here. In all seriousness (though, yes, that picture is below), I believe this article can help readers understand why dividend investing is critical in your path to financial freedom or at least financial independence! What my goal here is to show you how you can keep more of the money that is being sent your way, instead of having to give it away without a second-thought. That way, you can continue to strive, accomplish your other passions, as well as have the liberation to pursue interest & to commandeer others on their journey!
$50,000 Wage Income vs. $50,000 in dividend income
Now, in this study, we will take a single individual whom makes $50,000 in wage income vs. an individual who earnings $50,000 in qualified dividend income (For a definition of qualified dividend income, see bottom of post). We will not set in expectations of other ways to reduce taxable income, in this example, such as contributing to retirement plans, 401k, HSA, student loan interest, etc.. We will keep this very Vanilla, even though that’s not my favorite ice cream flavor. This should be a pure way to show the differences in taxes that you pay from the two different sources of income.
Local Tax Comment: We will also state, maybe a little bias here, that the individual lives in a city in Northeast Ohio. This is from my city’s taxation website, just an FYI, “Non-Taxable Income: Income not taxed by municipalities includes: interest (1099-int), dividends (1099-div), Social Security, pension distributions, income from Board of Elections (voting booth), workers compensation, public assistance, state unemployment compensation, active service …..” Therefore, no taxation on dividend income.
State Tax Comment: However, since my State of Ohio tax instructions requests the federal tax return’s adjusted gross income, dividend income will be taxed at the State level, for this individual, at least.
Social Security Comment: “Only earned income, your wages, or net income from self-employment, is covered by Social Security. You may have to pay income tax on pensions, annuities, interest, or dividends, but you do not pay Social Security taxes. Those types of income are not on your Social Security record.” This, in a nutshell, means you do not pay social security taxes on dividend income.
So now that we have those facts above, what is the big difference between wage income of $50,000 from John Doe and $50,000 of income from dividend investing, you ask? I have created a table to display how the dividend income is taxed based on a quick IRS form 1040 breakdown. The $50,000 in qualified dividend income does not receive the following taxes: FICA (Social security taxes), Local Tax and is further subject to different tax rates (see below the table).
Tax rates on Qualified dividend income per our friends at the IRS –
“The maximum rate of tax on qualified dividends is the following. 0% on any amount that otherwise would be taxed at a 10% or 15% rate. 15% on any amount that otherwise would be taxed at rates greater than 15% but less than 39.6%. 20% on any amount that otherwise would be taxed at a 39.6% rate.” Similarly, you are taxed at 0% if you are in the bottom 2 brackets I explained in the bullet point above or you pay 15% if you are in the next 4 brackets. Keep in mind, this is for dividend income!
What did we learn?
Well, you can see here, your effective tax rate went from 24.43% to 3.50%. Only portions of your qualified dividend was taxable at 15%, and that’s the amount that would have put you over into the 25% normal federal tax bracket or $1,650 was subject to the 15% ($39,600 – $37,950) tax. Both individuals still take the standard deduction and personal exemption, further reducing the amounts that would be taxable. John Doe receiving wage income pays higher taxes, as well as pays local & FICA taxes, that definitely eat away at your purchasing power of the $50,000.
Bottomline, you received 27.70% more actual purchasing power (non-adjusted for any discount or inflation, etc..) if you were to receive qualified dividend income from dividend investing than from W2-Wage income. You have over $10,000 more that you can use to invest, spend, travel, than you normally would. Sounds easy enough right? Can’t we all just go out there and build a portfolio based on dividend investing to receive $50,000 in qualified dividend income a year? It’s NOT that easy, at all actually. Impossible? No, no it’s definitely not impossible.
-One would have have a portfolio of $1,428,571 that yields 3.50% in order to receive $50,000 in qualified dividend income… I am close to 20% there, but DAMN, only 20%?
-This is why living below your means and saving as much income as possible to fuel investments that produce this cash flow can provide such incredible results. You may find you also either a.) don’t need $50,000 to live per year to live or b.) can see what expenses you can reduce in order to fuel dividend investing to receive a better taxed form of income.
-Understanding how to dividend invest, is also key. We have a few areas such as our dividend diplomat stock screener, the power of DRIPing and other lessons (check the categories page for Investing Topics and I believe you can learn more about how to start dividend investing).
Overall – one can not only keep more of their money, but also can plan to reduce their time to financial independence sooner if the income is received via this source. There may be other complexities involved here and keeping in mind that this was broken down, via tax language, a single individual. Do you see errors in the above that I have missed out on? Are there other things to consider here? Please share below and/or contact us either through messages, twitter or facebook and we’ll respond back as soon as possible. I hope everyone enjoyed this and we’ll talk soon! Now go save money and invest the difference!