LIVING OFF THE DIVIDENDS

YOU CAN MAKE $50K TAX FREE ... BUT 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, nonregistered 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 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 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 four 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.