Federal Dividend tax rates
When anyone tends to talk taxes, the natural tendency is for folks eyes to glaze over. But what I am about to share here could save you a lot of money over the long run.
The great thing about the recently concluded fiscal cliff discussions is that they effectively make permanent the tax breaks that exist for dividend income. These can be quite significant depending on your total income earned from wages and salaries.
To summarize what was agreed, tax rates on dividend income for those earning less than $400,000 ($450,000 for families) have been set at 15%, while for those earning above $400,000 ($450,000 for families) has been set at 20%.
For those that who have marginal tax rates that exceed 15% ($36,000 income if you are single or $72,000 if you married) you are effectively incentivized to earn any additional income from dividends or investment income (such as capital gains) rather than from earned income.
Lets take a look at what this means practically. Assume that Stan is single and has an income of $50,000. And lets also assume that Stan has the option of earning an extra $10,000 in income from employment (“earned” income) or $10,000 of income from his passive dividend portfolio.
The $10,000 extra earned income from employment will be taxed at a marginal tax rate of 25% rate. That will leave our hardworking Stan paying $2,500 in tax on his $10,000 income, for a net take home of $7,500.
Now lets say Stan has been motivated to save up passive dividend income his entire life to achieve his independence. He doesn’t need to take extra shifts to get that $10,000 in extra income. He gets that from his dividends instead. On his $10,000 in dividends, Stan pays only $1,500 in tax, so he walks away with a $8,500, or an extra $1,000 compared to the first example where he earned that extra $10,000 in wage income.
Lets change the analysis slightly. Jean makes $100,000 and also has the option of taking extra work to earn an additional $20,000 in income.
Were Jean to earn that extra $20,000 through wage income then Jean would be paying a rate of 28% on that extra income. After a tax obligation of $5600 Jean would be left with $14400 after tax.
Lets assume that Jean has been focussed on building up passive dividend income. Here Jean would only be paying 15% on that income, which works out to $3000 in tax. She gets to take home $17,000 of her dividend income after tax.
Thats a saving of close to $2600 in tax compared to if Jean had got that $20k extra through earned income.
FICA, Medicare Taxes
Up to this point, we have only considered dividend and personal taxation. We haven’t factored in the effect of FICA (social security taxes) and Medicare taxes.
For each dollar of wage or salary income, there is a social security tax thats payable of 12.4% and a Medicare tax that is payable of 2.9%
If you are an employee, you are responsible for roughly half of the contribution thats required to be made toward social security taxes and medicare. You have to pay social security taxes in the amount of 6.2% of your earned income up to $110,000, while Medicare is at a rate of 1.45% on earned income. The good news for Stan and Jean is that they are employees and their employer takes care of 50% of the amount, If they were self employed, they’d be responsible for the whole burden themselves.
So for Stan and Jean, they are both paying an additional 7.65% of their earned income in taxes. For Stan, that works out to be $765 for his additional $10k in earned income. For Jean, the extra $20k in earned income creates an additional $1530 tax obligation.
And where the extra income is earned from passive dividends how much extra in FICA and Medicare taxes would they be paying? $0.
Lets take a look at a summary of where things stand. The “earned” columns represent where Stan and Jean receive their extra income via wage or salary, and the “dividend” column is where this income is received via dividend.
You can see that the effective rate of tax paid by both Stan and Jean is more than double where they earn the extra income as wage earners, rather than as dividend income. In Stan’s case, he loses close to $1,700 extra in tax from earning additional wage income, and in Jean’s case its more than $4,000.
Taxation can take a huge chunk away from your hard earned income, but with a passive dividend income stream you can really minimize that hit. I was expecting the worst during the fiscal cliff discussions and had thought that the dividend tax concession would be lost. The good news is that this has been approved and made permanent.
Strangely it almost makes earning extra wage income less lucrative than an extra dollar of passive dividend income. As a passive dividend investor, I’m determined to do everything in my power to take full advantage of the favorable tax treatment of dividends and I encourage all of you to do the same.