By now, you have come across 10’s, and heck maybe even 100 sites that are dedicated to dividend investing. You have dissected the dividend income reports and the figures that members are posting in the community. Further, you read 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.
Dividend Income and 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. This may be the reason 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.
the code
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 Adjusted Gross Income (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 can be found here, but in short:
4.) We will stick with singe tax-filer in our scenario.
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! My goal is to show how you can keep more money that is being sent your way, instead of having to give it away in taxes. Dividend income from dividend investing may catapult you on your financial 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 statement says, “Qualified dividends taxed at the same rates as a net capital gain.”. Similarly, you are taxed at 0% if you are in the bottom 2 brackets (see above). You do 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 19.80% to 3.00%. NONE of your qualified dividend was taxable at 15%. Now that is the beauty of divided investing. Both individuals still take the standard deduction, 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 20.95% 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 $8,000 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 25% there, but DAMN, only 25%?
-Living below your means and saving as much income as possible. Then, using those savings to fuel investments that produce dividend income 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
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!
– Lanny
P.S…. BERT:
This is why Dividend income is the best. That’s amazing how much of a difference between working income and Dividend income. Thank for the great post to really put that in prospective.
Fiscal –
Exactly, every $1 you earn in qualified dividend income goes so much further than wage income. That’s what the tax code has laid out for us!
-Lanny
Love it! Dividend investing is by far the best way for me to earn passive income. Thanks for sharing!
CD –
Exactly, it’s a very easy to begin and simple way to start building assets that produce income for you, and because the income is technically taxed at the corporate level – they are reducing it at the personal level for us.
-Lanny
Nice Post! More great reasons to love dividend income. Names Robert, and I am new to the ever growing DGI community!
Robert –
Welcome! I hope you find value here and within the rest of the community – never hesitate to reach out if you are curious about anything and think we can help!
-Lanny
Lanny,
Fantastic picture at the end there, I am sure you had fun posting that. Otherwise, you are correct. I have made this point to many people, who seem to brush it off as either hearsay or unimportant. People often forget the cost of working (commuting costs, wardrobe, health costs – like being in a sitting position for hours). Add that plus the extra taxes, and your time goes a much shorter distance for that dollar than your dividends do.
– Gremlin
Grem –
Haha, that picture.. no words for it really.
And yes – it stinks when there is a true tax-financial impact here. Further, I didn’t even get into the details of working… the hours lost in a car (if you have to drive there), dry cleaning, stress levels… you’ve hit it more on the head with your comment, well shared DG, well shared.
-Lanny
Thx for the detail explanation. I really like it. You could have also pointed that your $50K dividend income is likely to grow each year by a low mid-single digit number as compared to a 50K salary may not be able to keep it up the growth rate for the next 25 years.
As a business own, I’m also switching from an income paid by my employer to a dividend paid by my company. Same salary, but a lot more buying power 🙂
Cheers,
Mike
Mike –
HILARIOUS at the end, I love it. And you’re damn right – right now in reinvestment mode you have a div growth + DRIP. Afterwards, you still have a strong dividend growth rate to boot. You said it my man, loving it.
-Lanny
Love it! Hopefully the tax situation in the future does not change… or gets better.
Fun stuff!
ADD –
Exactly… the tax situation can always be subject to change, which – we know full well… very good points ADD!
-Lanny
ADD + DDs,
It will probably always be in the dividend favor. It favors rich, large shareholders – the exact people who pressure rule-makers in Congress and the associated personnel in the executive branch. It would shock me if that group went against their own interested and deep fried their golden goose.
– Gremlin
Agreed!
That is just amazing.
In Belgium, teh dividend income is always taxed at 30pct, after the origin country tax. a fair average is a total tax of 40pct. Afterwards, you pay nothing. so, that 50K would on average translate into 30K.
50K salary would turn into 21K after tax. This is without any deduction you could get elsewhere.
Same conclusion thus: aim for the 50K dividend!
Amber –
Love the currency translation with other rules/regulations and still seeing dividends comes out on top!!
-Lanny
Thanks for the lesson. So is it a bad idea to invest in REITS because their dividends are taxed?
Divdude –
Not a bad idea and can actually place those in a retirement vehicle to not pay the tax now. Further – they usually have higher yields than the normal div companies, due to to this and the requirement to distribute more than a majority of earnings to shareholders. But def. something to consider.
-Lanny
This is a really interesting comparison, and nicely presented!
I would be interested in the same sort of tax comparison of 1) income all from dividends and 2) income from the combination of selling portions of stocks (capital gains) and dividends. For example, one could look at $50,000 in dividend income by investing in dividend stocks paying something like an average of 4 or 5% yield. This is probably similar to one half of your calculations in this post. Then compare that to holding an equivalent amount of an all market ETF (something like VTI) paying 2% yield, and assume you make up the difference in income by selling a small portion of the VTI holdings each year. Which is better tax wise?
The reason I ask is because of the ongoing debate out there (which I am sure you are aware of) that “making your own dividends” using growth stocks or broader market ETFs can be just as good as investing solely on dividend stocks. However, I don’t hear people talk too much about the tax implications of dividend stock income vs. “making your own dividends” income approach. Your thoughts?
Karl –
Thank you very much for reading, first and foremost. Secondly that would be a fun little analysis to do. I think you’ll realize a lot could do with short vs. long term capital gains tax rates, where short term capital gains are at your ordinary income rates…
Tax implications are huge, as I just wrote – you’re paying different taxes on Short term! Here is the statement, “If an asset is held for one year or less, then sold for a gain, the short-term capital gain will be taxed at ordinary income tax rates.” And if you drop that statement on your friends – they’ll understand there could be better value from dividend investing, just my two cents!!
-Lanny
I expect taxes from a total return approach would likely be less on the whole. That’s because the capital gains tax isn’t paid on the whole withdrawal but only on the gains, plus the individual lots to be sold can be selected to minimize or maximum taxes as desired. That gives much more flexibility on determining when to pay taxes. So e.g. for a $1428571 portfolio at 2% dividends -> $28571 of dividends and then you would sell an additional 1.5% of “capital” to get $21428. But of that $21428 only (say) $10,000 of it might actually be taxable gains. Even at a short term rate that’s less taxes (much more at long-term rate) but in reality you’d likely sell some assets at a loss to reduce the taxable amount as much as desired.
I suppose a total return approach is also a bit more of a hedge against changes in the tax code but who knows how the tax rate will change going forward.
Anyway, thanks for a great write up showing the tax benefit effect of passive dividend income compared to regular income.
Best wishes,
-DL
Fantastic example Lanny and great picture of Bert haha! In Australia things are a little different, but dividends also produce a better result. No to mention it’s the best thing to do with your money anyway!
Mr DDU
DDU –
Glad you liked and saw the picture of Bert throwing down to what I think is a piece of a pig… I don’t even know what to say about that.
Pumped that dividends are still better, let’s go and get more/place more emphasis if we can!!
-Lanny
Great analysis. I realize your keeping it simple but two points. 1) Retiring to a non-income tax state will reduce the tax bite further, and 2) if you need to supplement the post tax dividends with tax delayed tax funds (IRA, etc.) the effective tax rate may be a little higher – but (if financially able) can be delayed further until RMDs kick in.
Charlie –
Thanks for your two points – you definitely are right – you can pick a better state no doubt. And you are again right – I hope readers check this comment out! I went for the straight forward, not the best-case scenario, but a great scenario nonetheless in my example, but you have added positive elements no doubt. Appreciate C!
-Lanny
HahA nice pic of bert. I love ribfest! Great chart didnt really realize how minimal the taxes are aince we are all registered accounts at the moment. Tfsas and rrsp
PCI –
Yep, if your tax advantaged accounts are already protected/not tax impacted, yet, then you are not going to see the impact. And yes, this picture of Bert is either hilarious or disturbing, I think that has correlated with if I have ate already or not.. haha, too funny.
-Lanny
Thank you for this excellent article and analysis. One thing that I think could be missing is a historical study of dividend tax rates. It’s my understanding that they have changed over time and may not always be treated this way. It would be nice to understand what the risks are of dividend tax rates changing in the future and how much they’ve changed in the past. That could potentially undermine this journey if dividends begin to be taxed as regular income. However, it seems doubtful that the government would want to discourage the public from investing in the economy. Another thing that would be nice to know is how bond etf distributions are treated for tax purposes. Thanks again.
DivShower –
Definitely will consider showing a history lesson of the dividend tax rates, no doubt, I really am intrigued to research myself, actually.
As for Bond ETFs – it depends on what the ETF holds… if the ETF holds taxable bonds – then the distributions are taxed not as qualified dividends but as interest payments, taxed at ordinary income rates. NOW… if the ETF holds Municipal bonds that aren’t subject to federal taxation, then you should be free from paying federal tax on the payments received from that ETF. Does that make sense?
-Lanny
I’m a big believer of this and is something I preach daily to however I talk to about dividend investing. Thanks for sharing this!
CD –
Same and appreciate the post, keep the information flowing to followers and listeners!
-Lanny
Great post. I’ve seen the two income types side-by-side before. Dividends are awesome. 🙂
IH –
It does come down to three words… dividends are awesome. OR, it can come down to these 4 words, Bert’s Picture is disturbing.
-Lanny
I just listened to several e-books on dividend investing. They help to keep me motivated. Yet not one of them made the point you’ve made in such a clear example. I think you should write a book or something. But this was very helpful and insightful. Thank you.
DP –
Humbled by your comment, means so much, truly. We are all keeping each other motivated, your articles, our articles, the numbers, theories, lessons, etc.. are all here to push us along the way. And a book… haha, stay tuned is what I’ll say!!
-Lanny
Great analysis. I’ve kind of always known the benefits to dividend investing, but I’ve never done an example like that. It really makes an impression to see the hard dollar differences between working and investing.
Ian –
Thank you and of course – I was anxious to put pen to the paper to really show the difference from the taxes, it’s SO wild. And guess what – we can do something about it ; )
-Lanny
Bon appetite Bert!
Nice post Lanny, great assessment of tax impacts on dividend income. What a difference compared to normal income from labor.
CF –
Always appreciate the comment, thanks for coming down to check it out. Amazing when you see the actual impacts from both sides, right in front of you. It’s incredible.
-Lanny
Yeah I’m shooting for the 1.5-2 million mark before I call it quits. I’m at about 400k right now so either about 1/3 or 1/5 of where I want to end up. It’s amazing though how it starts to really pick up speed after the first 100k though. Five years ago I think my net worth was closer to 120 than 400.
Duncan’s Divs –
NOICE! $400K, is so incredible, I don’t even care!! I would be very excited/will be very excited when I hit that mark. So in 5 years, your net worth/investments have climbed a few times over, excellent motivation for us!
-Lanny
And yet another reason to love dividend investing. We often talk about many of the benefits of dividend investing but never about the tax implications. I bet you loved writing this post you CPA freak! Thanks for sharing.
DHut –
Love the CPA Jokes, keep them coming, I can handle them, for now… but if you give me the jokes during Jan-March… woof hah. But yes.. the benefits of dividend investing marches on and here is another BIG reason we do it!
-Lanny
Hey guys,
What did you think of the article I recommended on sticking with index funds over stocks? The author made some good points regarding assembling a portfolio of stocks vs index funds for the long-term investor, don’t you think so?
1) Twenty years ago, a blue chip portfolio of dividend paying stocks likely would have included General Motors, and if you recall from the 2009 bankruptcy, GM’s common shareholders were completely wiped out. Investors who reinvested their dividends through GM’s DRIP got a minus 100% (total loss) return on their investment.
2) Several years ago, General Electric was widely considered to be among the “best” dividend-paying stocks, but in 2009, it slashed its dividend by 67% after its share price dropped by 56% in 2008. Thus, it would not be included in a portfolio that would be assembled today.
3) Apple is now considered a solid dividend-paying stock, and its very high historical return would substantially boost the historical return of a portfolio that includes it. However, twenty years ago, Apple was paying no dividend, so it would not have been included in a model portfolio.
4) Dividend investors are also missing out on companies that will have high returns with little or no dividend. Investors who own these companies (or rather index funds that own these companies) can create their own dividends by selling shares.
5) There is an enormous problem with assembling a portfolio of individual stocks based on a characteristic (such as increasing dividends) that you see today and then assuming that any historical alpha (return above a risk-appropriate benchmark) would persist into the future. Namely, you are making the assumption that you would have chosen the exact same stocks at the beginning of the period.
Thanks for the feedback and your thoughts!
Great post. Also you’re actually closer than 20 percent there if you think about it. The 20 percent you have now is working for you. You’ll be at 40% a lot quicker because of it.
Seedling –
Great call out on that, it is working hard and because of the up-front investment – will definitely/easily aid in getting to the next 40% faster, always. Thanks for the stop by DS!
-Lanny
Love the tax benefits! Weirdly enough, I talk about them all the time around tax season. Just need to not however, most of those calculations are based on tax sheltered accounts (401k, IRA, HSA, etc). If you have it in a taxable account for say, early retirement purposes, you will still be taxed at 15%. Either way you are saving 10% in taxes from not having it come from standard wages. Win/Win.
DDaze –
Exactly and that’s if you have a SUBSTANTIAL amount of divvy income. It’s incredible, but obviously as stated in a few other comments – we need to stay on top of current tax legislation that can cause changes to occur. But I hope that they are smart about this and if they cut corporate tax rates, then these should be cut even further… right?
-Lanny
Another interesting point is that presumably, the dividend income earner doesn’t have to put aside anything for retirement.
Well technically they are putting aside the 1.2MM in stocks to get the dividends.
It’s amazing what the government takes from wage earners in taxes. You know, I wonder if THIS is why there’s no financial education in this country. If you were the government, why would you want people to know this?
Sincerely,
ARB–Angry Retail Banker
One big thing you left out is the guaranteed raise every year for being a share holder. I love getting pay raises while I relax!
I’m excited to see the annual pay raises to be honest with you. We won’t have to touch our best egg in order to live. Pay raises be like $52,500 the first year, $55,125 the next, ect ect. Man it gets me pumped.
Great points about dividends being treated more favorably than earned income. That is certainly true at the federal level, and in some cases, the city level.
At the state level, however, these 2 types of income are treated as equivalent in nearly every state. In Tennessee, dividends are taxed, while earned income is not, but they are phasing out the dividend tax. New Hampshire also taxes dividend income, but not earned income. I’m not aware of any states treating dividend income better than earned income.
In MN, I pay a 9.85% state income tax on any dividend income. It’s a high tax state, but that’s my reality.
Best,
-PoF
Thanks for sharing this! I learned a lot more from this post and will use it to my advantage. I would still make sure I’m taking full advantage of my Roth IRA to help alleviate some of those taxes. Who am I to kid especially at a 3.5% effective tax rate. So. Much. Gains.
Wow! At those current tax rates it makes sense why someone would.
1) want to max out pre-tax accounts.
2) build a dividend portfolio that avoids being hit with massive taxes.
This wrote up surely shows us in a clear straightforward way how taxes can eat away at our income. You are right in saying that one needs to save and invest as much as possible as soon as possible. Hopefully in 10-15 yrs. one can look back and say, man I’m glad I saved $1,428,571 now I can relax and live off that generous dividend. All while paying slightly more than 3% taxes.
Dr. Div –
I couldn’t have said it better myself. EXACTLY.
-Lanny