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.
Analysis
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.
Wrap Up
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.
Dividends are great. They are like a bonus for investing We try to reinvest the ones we get .
Miss T,
Thanks for coming by. I completely agree that dividends are great. They help you have a nice side income and are tax efficient as well!, Reinvesting the dividends is a good way to rapidly grow your investments as well as generate even more dividends!.
The reality is that we don’t get an either/or option of dividends or wages. We all start with wages (except trust fund kids) and have to build dividend streams by saving and investing. I have no problem earning extra wage income. That’s just more money that can get turned into dividend producing investments. What I like about dividends is that if I ever decide to exercise my future financial independence that taxes will take a much smaller bite out of my income.
My FI,
Completely agree on extra wage income….. I’d never say no to an extra payrise either!. Dividend income does provide a good way to hang onto more of what you get and significantly lower your effective tax rate in the process. The tax perks are just a nice added benefit on the road to financial independence with dividends.
Hi intergrator,
Thank you for writing this article. I am currently investing my extra money in a Roth IRA because I like the idea of tax free dividends. Moreover, my bills are low that I do not need the extra income at this time in my life. Would it make more sense for me to grow a dividend paying portfolio outside of the roth account or continue to stay with the Roth account? For what its worth, I have about 7k in the Roth and have been growing it for 1 year. In addition, I will not be contributing too much to it over the next year and a half as I am saving for my wedding in October, then saving cash for a down payment. Any advice would be appreciated.
Hi Mike,
In my view, holding your dividends in a Roth IRA is generally more tax efficient than having them in a taxable account. The only downside is the is a penalty if you want withdraw any distributions from the Roth IRA before you turn 60. I think the penalty may be 10% on whatever the IRA has “earnt”, The reason I hold my dividends in a taxable account is because I currently have active use for the dividends and certainly plan on regularly tapping into my dividends stream to live off before 60.
Integrator.
Gotcha. So it is just personal preference. I think I am going to make the switch as I would like to create a passive income stream. In addition, I will have my employer 401k as my safety net
Grea post! This is one of the best write ups I have seen on the topic. I like how you articulate your argument this visualize it for the reader. Working for money (wage) is very burdensome I would much rather earn my money through passive income.
Thanks Marvin,
I completely agree that working for money can be burdensome! Passive dividend income lets you keep a lot more of what you make.
Integrator
Great topic and post.
The favorable tax treatment towards dividends is one of the most lucrative and attractive aspects of this investment strategy. It’s one of the main reasons I plan on retiring on a relatively small annual total of dividends. The lack of any serious tax bite makes this significantly easier.
Best wishes!
DM,
Thanks for the comment. I agree that if you actually factor in taxes, you can probably cut significantly what you would otherwise need to assume as necessary income for retirement from dividends. Taking into account social security and medicare tax savings will also make a big difference.
Integrator
I love dividends for all the reasons you mentioned. To me owning dividend stocks is like owning rental property, where the value of the stock itself is like the house, which will hopefully appreciate in value, and the dividends earned are like rent payments received.
The only thing that makes me nervous is how easily our tax code can be changed. I feel like those with dividend income dodged a bullet on this last go around and I’m afraid the more desperate our government gets for revenue, we might not be so lucky in the future.
Great post.
Thanks for stopping by Julie. I certainly had the same fears that you did about whether the dividend tax concessions would survive. I feel that now that they’ve at least moved beyond being extended another year that we should be looking at some type of semi permanence for these changes, and I’d expect the dividend tax cuts to hold for some time to come. Of course nothing is ever certain in politics!
Definitely tax advantageous! I’m compiling my latest passive income report now and I think I’m around $20k or so in dividends.
Don’t we have a new 3.8% Medicare tax on adjustable income over $200k though?
Sam
Hi Sam,
Thanks for stopping by!. You are absolutely correct. For folks earning adjustable gross income more than $200k (or $250k for a family) any dividends and capital gains will attract an 3.8% Medicare tax. I probably should have done an additional illustration assuming Jean got a promotion which took her to $200k!
Integrator
I have an entire portfolio of direct stock purchase plans in a handful of blue chip dividend stocks. I continually allow the dividends to reinvest over and over again. At some age I might take the cash, but I am more than happy to continue to accumulate additional shares when I would probably spend it stupidly if I took cash.
Hi Scott,
Thanks for coming by. Dividend reinvestment will stand you in good stead over the long term. Its a great way to accelerate building passive dividend income. As you say, if you don’t see it you can’t spend it!
Integrator