How To Pay 0% Income Tax in Retirement

How To Pay 0% Income Tax in Retirement

Ah retirement. Or, as my 85 year-old grandfather who still works calls it, “stop being a quitter, pussy.”

(For the record, Gramps works about an hour a week, if that. And most of that time is spent yelling.)

Many people who read this here vomit-encrusted blog imagine a retirement fully funded by dividends. This is why most dividend-growth investors become dividend-growth investors. All they need to do is earn enough to survive during retirement and they’re confident the portfolio will churn out enough raises that inflation won’t be a worry.

People without as much capital will use a combination of CPP, OAS, and various dividends to make ends meet. Or they might get a pension. Remember, it’s going to be easy to get by on a reduced income once you retire.

And so on. This is pretty easy stuff.

It turns out there’s a different reason why you might want to rely on dividends when you retire. Because you won’t pay much tax at all. In fact, if you make under $50,000 per year and live in the right province, you’ll pay 0% income tax in retirement.

Pay 0% income tax

Let’s talk a little bit about the treatment of dividends come tax time. I’ll sexy this up as much as possible, but be prepared. It’s gonna get boring.

First, know the difference between eligible dividends versus non-eligible dividends. The former you get from a publicly-traded Canadian corporation. The latter you’d pay yourself out of your own company.

Say you get $10,000 per year in eligible dividends. When it comes time to pay tax, the government will gross up those dividends to $13,800 and you’d get a dividend tax credit of 20.73%.

So if you’re in the 33% tax bracket, you’d end up paying tax of about 12% of $13,800, or about $1,656. If you received $10,000 in interest payments, you’d be looking at a total tax bill of $3,300.

You can see immediately why people like dividends so much.

Knowing that, let’s dive a little into Canadian tax brackets. All we’ll need to concern ourselves with is the first one, which covers the first $45,916 of earned income. The federal tax rate on that is 15%, and then you’ll have a provincial rate on top of that.

And then there’s the personal exemption, which runs around $11,000 per year.

Let’s assume a simple scenario. A retiree gets $7,000 per year in CPP, $7,000 in Old Age Security, and $25,000 in dividends from your basket of stocks. You live in Alberta because that’s where all the cool kids live.

How much tax will you be paying? The answer is $490. On $39,000 in income. That’s because all the retiree is really paying tax on is the difference between the personal exemption ($11,000) and the amount earned by CPP/OAS ($14,000). Tax on $3,000 worth of income at 15% puts us almost at $490.

Let’s do one better. How about if our imaginary person makes $39,000 per year in just dividends? How much tax would they pay?

The answer is zero — at least in Alberta.

Assuming you have no other income, you can earn about $55,000 in dividends in Alberta and still pay 0% income tax. Depending on the province, taxes will kick in sooner. It depends on each place’s different provincial taxes.

One thing is for sure. It’s way better to get dividend income rather than working. No matter what province you live in.

I played around with a tax calculator and came up with this table. It’s based on $50,000 per year in income from a job or from dividends in each province.

Province Tax working a job Tax on dividends
B.C. $8,372 $0
Alberta $9,193 $0
Manitoba $10,822 $1,780
New Brunswick $10,423 $0
Newfoundland $10,204 $3,004
Nova Scotia $10,945 $1,810
Ontario $8,405 $0
PEI $10,875 $360
Quebec $11,036 $1,583
Sask $9,904 $0

Thanks to TaxTips.ca for the tax help. Any errors are mine, not theirs.

Anyway, it’s not even close. There are huge tax advantages to holding a basket of dividend-paying stocks come retirement. You can make a decent amount of money before the government starts taking their share, too.

Should this affect your investing today?

The interesting thing isn’t that this exists. The question is how should you invest?

I can see the logic in wanting to have a nice dividend portfolio come retirement time to take advantage of this. But should it dictate your investment thinking 20 or 30 years before retirement?

Some people say yes. After all, dividend-growth stocks do tend to outperform the market over time.

But there are other approaches that outperform over time, too. Buying small-cap value stocks has worked. So has buying net-net stocks.

I’ll admit that as I get busier writing I’m less inclined to research individual stocks. I like the idea of a buy and hold portfolio without much turnover. The market is also pretty expensive, so looking for cheap stocks bums me out a little.

The bottom line? I can see the logic in building up a dividend portfolio today, but you don’t have to do it. The whole point should be to accumulate the biggest nest egg.

Conclusion 

Alright kids, that’s enough. It turns out that if you have a portfolio filled with dividend payers and no other income, you too can pay 0% income tax. That alone is enough for me to encourage y’all focus on dividends come retirement time. What you do in the meantime is up to you.

The Canadian Guide To Whether You Should Incorporate

The Canadian Guide To Whether You Should Incorporate

It all started about a year ago. Actually, probably longer ago than that, most likely. I’m not good at using calendars. I still think it’s 1952.

In an effort to save taxes, I started looking into the benefits of incorporating my small business. I liked the ability to retain earnings in the corporation, as well as not having to pay any CPP contributions.

At that point, I abandoned the idea, since all of my business revenue was coming from one source and the government tends to frown upon such a thing. I decided I’d rather be safe than sorry. The last thing I want to do is piss the government off. Those jerks know where I live, but they’ll never get my phone number. That’s why I change phones every week, like a drug dealer.

These days, things are different. I’ve successfully diversified to the point where only most of my revenue comes from one client, picking up a few additional jobs along my travels. So I went ahead and folded my writing into a corporation.

The rationale for doing so was simple. I wanted to save taxes. But was I really doing so, or am I just fooling myself?

Let’s take a closer look, using a corporation in Alberta as an example.

Assumptions

We’re going to assume somebody makes $100,000 per year in revenue with $10,000 per year in expenses as both a sole proprietor and as an incorporated professional. We’ll assume zero in GST paid or anything like that because no matter how you structure your company the government still gets their share of that.

(Shakes fist aggressively) That’ll show them.

First, let’s look at the tax situation of a sole proprietor in Alberta.

Revenue: $100,000
Expenses: ($10,000)
CPP Contributions: ($5088.60)
Operating income: $84,911.40

Tax paid: ($19,841)

Net income: $65,070.40

And now the same person after they incorporate.

Revenue: $100,000
Expenses: ($10,000)
CPP Contributions: nil
Operating income: $90,000

Corporate tax (AB): ($2,700)
Corporate tax (Can): ($9,450)
Total tax paid: ($12,150)

Net income: $77,850

HUZZAH! PLAY ME A NICE SONG, GLORIUS TRUMPETS. I HAVE SAVED YOU ALMOST $13,000 PER YEAR.

Uh, Nelson?

Stop it. I’m celebrating.

What if they wanted to take that cash out of the corporation?

Really? Do you have to rain on my parade?

I’m just saying it’s an important detail.

AND I’M JUST SAYING YOU’RE A BIG FAT TURD.

Italicized me is right, of course. Here’s how the tax situation differs when you take that cash from the corporation and put it in your back pocket.

You have one of two ways of doing this. You can do it as a salary, which is subject to normal tax rates or you can do it via dividends.

There are pros and cons to doing it both ways. The big pro to taking the cash out as salary is you get RRSP contribution room to go along with it. Utilizing that room minimizes tax in the short-term. Meanwhile, the dividend method results in a metric assload of reduced taxes.

Here are the two tax situations.

Salary

Net corporate earnings: $77,850
Personal taxes: ($17,688)
CPP contributions: ($5088.60)*
Net personal earnings: $55,073.40

*Some of this would be a taxable expense to the corporation, but like hell I’m going to try to figure it out. My brain already hurts.

As you’ll see, it costs a lot to give yourself the ability to make RRSP contributions.

Dividends

Net corporate earnings: $77,850
Non-eligible dividend taxes: ($9,346)
Net personal earnings: $68,504

So, to sum it all up, if you incorporate your business and then take the earnings out as dividends, you’ll put an extra $3,500 in your pocket each year compared to just running as a sole proprietor, at least according to my very specific scenario.

Remember, though, running a corporation comes with extra expenses compared to running a sole proprietorship. You have annual expenses to maintain a corporation. And accountants tend to charge more to do corporate taxes compared to personal returns.

So, in short, you’ll put some extra money in your pocket if you incorporate, but it’s also easy to justify not bothering.

How to put even more in your pocket

The nice thing about a corporation is you don’t have to take the money out immediately. You can leave it in there. This move alone can really help to maximize your income over the long term.

Say we use our example above. Instead of taking all $77,850 out of the corporation, say our employee only takes $44,000 out in dividends. This would lower his total tax bill from $9,346 to just $2,632.

Here’s how it would look:

Net corporate earnings: $77,800
Dividend taxes: ($2,632)
Subtotal: $32,500 (left in corporation)
Subtotal: $41,368 (after dividend taxes)
Total: $73,868 (total of the two)

There are a few problems with this scenario, of course. The first one is perhaps this person needs the full $77,800 to live. It doesn’t factor in any other tax considerations either. And why bother making $100,000 per year if you’re only going to take $44,000 out of the corporation?

Perhaps most importantly, you’re going to create a surplus of funds inside the corporation that could build up for years. This isn’t such a bad thing if you’re running a business that requires capital for growth. But what about a guy like me who’s limited to, basically, exchanging time for money?

I’m forced to invest that capital inside the corporation, which comes with much higher tax rates. Alberta charges a 12% corporate tax on investments while the federal government really wants to discourage investing inside of a corporation with a tax rate of 38.7%.

This is where things start to get too complicated for my layman’s knowledge of taxes. There are certain tax credits that apply to corporations getting investment income in each province. The fine folks at CIBC did attempt to tackle this question in this report I found while Googling.

Allow me to screenshot the results below after this little explanation. If a number is (in brackets) that means it’s a disadvantage to investing inside of a corporation. If the number is normal, it’s an advantage.

Screen Shot 2016-07-26 at 10.38.04 PM

So basically, as someone who’s from Alberta, it looks like any advantage I get from corporate versus personal taxes will probably get eaten away over time by these investment disadvantages.

What about Ontario?

Many of you live in Ontario. Allow me to see just how much of an advantage you’ll enjoy incorporation versus going the sole proprietor route.

Sole proprietor taxes:

Income: $90,000
CPP: ($5088.60)
Operating Income: $84,911.40
Taxes: ($19,016)
Total: $65,895

Corporate taxes:

Income: $90,000
CPP: (nil)
Operating Income: $90,000
Ontario corporate tax (4.5%): ($4,050)
Canada corporate tax: (10.5%) ($9,450)
Subtotal: $76,500
Dividend taxes: ($7,452)
Total: $69,038

Corporate taxes (if withdrawing $44,000 in dividends)

Subtotal: $76,500
Dividend taxes: ($1,221)
Total: $32,500 (left in corporation)
Total: $42,779 (dividend income after tax)
Total: $75,279 (total of the two)

Because Ontario has much lower tax rates on dividends than Alberta, taking out $44,000 per year in Ontario works better than it does in Alberta. And since Ontario’s corporate tax rules are more friendly towards investment income than Alberta’s, that advantage continues. This means it makes far more sense to keep as much cash as possible in your corporation if CIBC is to be believed and makes the decision to incorporate in Ontario a much easier one than Alberta.

This presents an interesting conundrum for me, personally. Do I take my corporate earnings and take them out of my company, or do I keep them in knowing I have a tax disadvantage in doing so? Sure, I can put about $5,000 per year in my pocket by only taking some of my earnings via dividends. But I’m also losing out on opportunity costs if I just let that money sit there.

Let’s wrap it up

So, to summarize:

  • It likely does make sense to incorporate, especially with CPP premiums going up. Remember, self-employed folks have to pay both halves of CPP contributions.
  • It makes sense to only take a portion of your earnings as dividends if possible.
  • It may make sense to invest in the corporation over investing personally, although this does not seem to be the case in Alberta. In this case, you’d take only the bare minimum out of the corporation.
  • If you live in Ontario, it sure looks like incorporating is the ticket. You can put $10,000 per year in your pocket by being smart with dividend withdrawals. And it looks like it’s better to invest inside of a corporation in Ontario too.

However, before you do any of this, talk to a tax expert. I think I have the gist of this down, but I’m only one man with fair to poor Googling skillz.

Thanks to the helpful tax calculators at taxtips.ca for making this a whole lot easier for me.

Annual Reminder: Whining About Taxes Is Stupid

otto-taxes

It’s tax day for the nine Financial Uproar U.S. readers, but it isn’t a big deal. I know you kids are up with what’s down (or is it down with what’s up? Lingo confuses me) and had your taxes all completed by January 2nd.

Whenever I think of someone scrambling to finish their taxes, I’m reminded of The Trouble With Trillions, one of my favorite Simpsons episodes.

Homer: Marge, how many kids do we have? Oh, no time to count, I’ll just estimate! Uh . . . nine!
Marge:Homer, you know we don’t have–
Homer: Shut up! Shut up! If I don’t hear you, it’s not illegal! Okay I need some deductions. Deductions… Oh, business gifts! [hands Marge the sailboat painting from above the couch] Here you go, keep using nuclear power.
Marge: Homer, I painted that for you.
Homer: Okay, Marge, if anyone asks, you require twenty-four hour nursing care, Lisa’s a clergyman, Maggie is seven people, and Bart was wounded in Vietnam.
Bart: Cool!

Let’s take a minute and talk about tax brackets, one of the most misunderstood concepts of personal finance. I’m going to consult the Canadian Government’s federal tax guide for this, because yes, I was just talking about U.S. taxes a minute ago. I just like confusing people. Makes me feel smart.

Screen Shot 2015-04-15 at 5.12.12 AM

There’s obviously provincial taxes on top of these, but we’ll ignore those. Let’s keep this exercise as simple as possible.

For your first $44,701 in income, you’re paying the feds 15%. Pretty straightforward, huh?

For your next $44,700 in income, you’re paying 22%. No, I don’t know where there’s a dollar difference STOP ASKING GEEZ LOOK THIS CRAP UP YOURSELF.

Let’s stop there. What’s your tax rate so far?

It’s a simple question. You paid 15% on the first half of the income, and then 22% on the other half. So if you made exactly $89,401 in 2014, you’d pay income tax of 17.5%.

Here’s where it gets a little more complicated. Say you made $100,000 hitting up fat kids for their lunch money, and for some reason are declaring it as income. What’s your tax rate?

On the surface, it looks to be a pretty simple calculation. You’re paying 26% of each extorted dollar back to the feds, probably going towards Stephen Harper’s hair gel.

But is it that simple? Or should you look at the average tax rate paid?

Let me communicate this in a table.

Income Percent Taxes Total Tax Paid
$44,701 15% $6,705
$44,700 22% $9.834
$10,599 26% $2,755

In total, on $100,000 in income, you’re looking at a tax bill of $19,294. My crack math skills tell me that’s a tax rate of 19.3%.

The point is this. Even though each additional dollar is being taxed at a 26% rate, the amount you pay is still being weighed down by all your previous income in lower brackets. Instead of being in the 26% bracket, I’d argue someone who makes $100,000 is in the 19.3% bracket, which grows at 26%.

Is it shoddy accounting? Well, maybe. But wouldn’t you do the same in your portfolio if you were looking at straight dividend yields? Or if you ran a store and was looking at your total margin? So why should taxes be different?

“I refuse to make more. It’ll put me in the next tax bracket.”

Raise your hand if you’ve ever heard a version of that idiotic statement.

(You did it, didn’t you? Nice work, dingbat. Now Phyllis from accounting things you’re extra special.)

I think you should do everything legally possible to avoid taxes. You can start a business for the deductions and the ability to shelter the earnings inside the company. You can use spousal RRSPs or income splitting or buying assets in the lower earning spouse’s name. Hell, you can even pay her to look pretty, although I’d advise pretending she does your books.

I’m all for minimizing taxes.

But after that, you should pay. Without taxes, Canada’s healthcare system resembles Murica’s, toll roads exist everywhere, and we’re all going to school at Bill’s barn, which smells exactly like you’d expect. Okay, maybe not, but the point stands — taxes pay for these things. If you use them, you should pay.

If you’re successful enough to make it into the 3rd or 4th tax bracket, I say stop bitching and go to work. You’re in a position that millions of people would kill to find themselves in, and you’re not taking advantage of it to screw over the government? That’s more shortsighted than Martha Stewart’s decisions around her Imclone stock.

Again, take all the legal steps you can to minimize your tax bill. But after that, I expect you to go out and build all the wealth you can, taxes be damned. Like my dad likes to say, embrace paying taxes. The more taxes he pays, the happier he is, because he knows a high income translates to wealth. I think we’d all be better off if we had the same attitude.

Foreign Dividend Tax Rules For Canadians

If you’re any kind of investor, you’ve got both Canadian and U.S. stocks.

Having all your assets tied up in Canada is silly. What happens when Quebec finally gets the bomb? You know those crazy poutine eaters won’t hesitate to nuke Alberta and then try to ride in and take the oil. They won’t succeed because MURICA will beat their asses to it, but still. It’s fun that they try.

Of course, the real reason why you shouldn’t have all your investments in Canadian dollars is because our economy isn’t really that important. Sure, we’ve got the oil and a lot of minerals, but that’s really about it. We’re not a superpower, we’re just pretty good. Think of us as the nation version of Ben Affleck’s little brother.

Besides, Canada is a whole 3% of the world’s economy. Our biggest claim to fame is our overpriced housing market, and maybe the fact that we’re America’s hat and/or largest trading partner. Oh, and Alberta will get mad if I don’t point out the oil thing again. Canada is a housing correction and a decent electric car away from turning into Poland.

Which is why, if you’re a canuck investor, you should hold at least some U.S. stocks. You could get all technical and say that everyone should own stocks from around the world, but let’s not go nuts. A lot of U.S. stocks have significant worldwide operations anyway. Besides, it’s easy to buy many foreign stocks using ADRs that trade in the U.S.

Assume you bought a U.S. stock that pays a dividend. Which account should you hold it in?

The answer is really simple — your registered one. As in, your RRSP.

Here’s what happens when you hold a U.S. stock in a registered account, and you get a dividend.

1. You get the dividend
2. There is no step 2, sucka
3. Uh, I dunno
4. Has this joke gone on too long?
5. Yes. Yes it has

Meanwhile, if you hold a U.S. stock in a regular margin account, the IRS will take a 15% withholding tax. You can apply to get that withholding tax back from the CRA, since the U.S. and Canada have a tax treaty. But unlike with Canadian dividends — which are taxed at a discounted rate — U.S. dividends are taxed as normal income. That means, depending on the tax bracket, you’d pay about 10% more in tax on U.S. dividends.

The TFSA is a little different. You’ll get dinged the 15% withholding tax, but that’s it. So again, it pays to hold U.S. stocks in your RRSP and stick Canadian ones in your TFSA or regular ol’ account.

Rules are slightly different for other parts of the world. Say you bought shares in Siemens, a German company. It pays a nice 3.25% dividend, and generally you’ll get withheld 15% of the income in both a registered or non-registered account.

The difference is that you’ll be able to get the tax credit from the taxable account, and not the RRSP. So it makes sense to hold foreign stocks that aren’t U.S. based (including ADRs that trade on U.S. stock exchanges) in your taxable account, at least from a dividend perspective.

Sometimes though, the country withholding the tax won’t know where the investor is from, and withhold the maximum amount of tax allowed. In the German example, it might be 25 or 30% of the value of the dividend. As a Canadian taxpayer you can apply to get your tax credit to get the 15% back, but that’s it.

Assume this happens with Siemens. Suddenly your 3.25% dividend turns into a less impressive 2.93% dividend, based on the 25% withholding tax and the 15% credit. And remember that you’re paying full tax on that, so in reality it’s more like a 2.75% dividend.

If you’re buying a stock based on the assumption that it’s undervalued and is likely to go up a lot, taxes are just a cost of doing business. Other governments don’t get in on the action of taxing capital gains on stocks.

But if you’re buying a stock for income, Canadian stocks continue to be your best bet. There’s no withholding taxes, and they get taxed using the dividend tax credit. I understand wanting to diversify across borders, but at least from a tax perspective, it’s not such a good plan.

Finally, Financial Uproar Gives Tax Advice

I’ve been writing on this here blog for over 4 years, an impressive feat considering the average blog only lasts a day and a half before the owner realizes their cute stories about their cat just aren’t entertaining. (I’m estimating here, your actual blogging experience may vary) I’ve churned out approximately 1.4 million posts, you’ve all commented 2.7 billion times, and collectively we’ve wasted 3.93 quadrillion hours that we’ll never get back. Uh, sorry about all that.

There’s good news though. Finally, I’m about to present some actual useful advice. I’ve avoided talking about taxes this whole time, mostly because paying them depresses me worse than being single on Valentine’s Day. (Topical!) Like a good little guy I dutifully pay my taxes each quarter, and then at the end of the year I hand my taxes to my accountant, who does them for free, probably because I’m so awesome. Or maybe it’s because we’re related.

Anyway, now that I’ve started on the topic, you’re all probably wondering what tax tips I have for you. Considering the source, I’m sure it’s assumed that I’m writing off lap dances and all the expenses associated with keeping all my internet girlfriends happy. Alas, I don’t really have those expenses, mostly because I’m a cheap bastard but also because none of my internet girlfriends will return my calls. And I’ve tried. A lot.

Anyway, onto the actual tax tips.

Max Out Your RRSP

Here’s an easy way to reduce your tax bill by at least 15%. All you have to do is max out your RRSP.

Yes, I realize you’re going to have to pay tax on it once you retire, but that’s like, a million years away. There’s value in delaying tax for decades. There’s little guarantee that your taxable income in retirement is going to be significant or that tax rates will rise over the next 40 years.

Besides, it’s all about the current value of money. If you get a tax refund now and invest it for years, it’s much more valuable than maybe paying less tax at some point in the future. Guaranteed money now is generally worth more than non-guaranteed money in the future.

Actually Reinvest Your Tax Refund

If you’re a regular schmoe, chances are you’re getting some money back from the government. That’s because your company generally will take a little too much, so you don’t come back in March and rip HR a new one because you owe the government taxes. So congratulations, you’re getting a refund. IT’S NEW TV TIME, BITCHES.

Uh, no. You just gave the government an interest free loan for months. Giving people interest free loans is typically a bad PF move, but it’s okay, there’s no need to beat yourself up about it. Provided, of course, that you do something smart with that tax refund. If you invest it, not only will you get a head start on next year’s RRSP contribution, but you’ll also be able to make an extra 6 months worth of gains.

And while we’re on the topic, get HR to adjust your exemptions so you’re not getting a giant refund. It’ll only take a few minutes, I promise.

Read Your Tax Forms

The relative that does my taxes is old school, probably because he’s old enough to remember life without TV and flush toilets. So instead of using tax preparation software, he actually uses the forms. Besides the forms, Canada Revenue Agency will also make available a handy guide to changes made in the tax code compared to last year. Make sure to actually read this, you may have exemptions for stuff like buying a new house, doing renos, or for one of the million things your kids did that costed you money.

Or, you could get some tax preparation software and let it tell you about all the new deductions. You hear that, old relative? Of course not. Like he knows how to use the internet.

Let’s Give Away Some Stuff, Yo

Thanks to the fine folks from H&R Block, I’ve got two codes to give away to their online tax software, which will definitely make your life easier. Also cheaper, since the software usually will set you back $29.99. See, I’m saving you money already. Well, assuming you win.

Here’s how you enter. You send one erotic picture to – wait, I’m being told that’s inappropriate. Instead, just leave a witty comment. Or a not-so-witty comment. Or hire a monkey to leave a comment for you. It’s all good. We’ll run the contest until the next Sunday Link Dump, where I’ll announce the two randomly selected winners. You can only enter once, so no stuffing the virtual entry box, cheater.

Good luck to all who enter. Tell all your friends. Hell, even tell your enemies. It’s all good. And if you don’t win, click here to buy your own H&R Block Canada Tax Software.