Nothing can be said to be certain, except death and taxes.
Benjamin Franklin 1789.
When I wrote about our financial independence assumptions back in July, many readers asked if we were taking taxes into consideration. As the great Benjamin Franklin pointed out many years ago, taxes is definitely something that we must plan for in life. How much taxes do we need to pay on our divided income? Let's take a closer look at our financial independence assumptions.
Disclaimer: I'm not a tax specialist. This post is simply my interpretation of the Canadian income tax system. Please consult a tax specialist regarding your income tax.
Our Financial Independence Assumptions
As you may recall, we broke down our core expense per month estimate.
House property taxes $350
House maintenance $50
House insurance $100
Internet & cellphones $100
Household supplies $100
Car insurance for 1 vehicle $120
Gas for 1 vehicle $50
Car maintenance $50
Since our core expenses do not include things like eating out, charity donations, entertainment, vacation, and education savings, we will add $950 per month to cover these non-core expenses.
This results in $3,220 per month in expenses, or $38,640 per year. For simple calculation, we will round this number up to $40,000.
So, to be financial independent, we need our dividend portfolio to produce $40,000 per year. While we do plan to continue some part time work when we are financial independent, dividend income will be the primary source of income.
Don't you have to pay taxes on the $40,000 dividend income?
Yes but that's the beauty of our dividend portfolio - we do not hold all of the dividend paying stocks in taxable accounts. We hold many of these stocks in tax advantage accounts like RRSP and TFSA.
RRSP (Registered Retirement Savings Plan) is a tax deferred account that is similar to the 401(k) in the US.
TFSA (Tax Free Savings Account) is a tax free account that is similar to the Roth IRA in the US. But there's no age restriction on withdraws. We can withdraw money at anytime.
To make sure we are tax efficient, we hold all Canadian REITs and income trusts in TFSA. All US stocks and ADRs are held in RRSPs. We maximize our RRSP And TFSA before making any investments in taxable accounts.
Our Dividend Income Breakdown
Table below shows the dividend income breakdown of our dividend income in 2015 and so far in 2016.
How come over 45% of our dividend income comes from TFSAs?
Because our TFSA consist a number of high yield stocks like REITs and income trusts. We also hold Canadian dividend stocks in our TFSA. These Canadian dividend stocks tend to have higher yield rates compared to their US counterparts.
Due to RRSP withdrawal rules, it does not make sense to receive a large amount of dividend income from our RRSP (I'll explain this later). So, we will need to start focusing on adding dividend stocks in TFSA and taxable accounts rather than RRSP. When we are financial independent, our ideal dividend income breakdown is 20% RRSP, 50% TFSA, and 30% taxable.
Taxes in Financial Independence - Scenario 1
What happens to income tax when we are financially independent and we are receiving $40,000 in dividend income per year? Using the 20% RRSP, 50% TFSA, and 30% taxable breakdown from above, our income breakdown would be:
- RRSP: $8,000 (taxed)
- TFSA: $20,000 (tax free!!!)
- Taxable: $12,000 (taxed)
Note: We will assume the taxable dividend income is split 40-60 between Mrs. T and I.
There are tax consequences when withdrawing money from RRSP. Therefore, we need to come up with a withdrawal strategy. Our RRSP withdrawal strategy is to split the withdrawal amount between the two of us. Below are the RRSP withholding tax rates:
Since we are splitting our RRSP withdraws, we can withdraw $4,450 each and still receive $4,005 after paying 10% ($445) of withholding tax. The amount withdrawn is then considered as employment income.
When we file our income tax, our annual taxable income would look like below:
- Mrs. T: $4,005 employment income from RRSP + $4,800 eligible dividend income
- Tawcan: $4,005 employment income from RRSP + $7,200 eligible dividend income
Because we do not know future federal and provincial tax rates, we will use the 2016 income tax calculator by SimpleTax for estimate purposes.
That's right! We pay $0 in taxes if we rely 100% on our dividend income. We will be getting the entire $890 RRSP withholding tax back. How cool is that?
Taxes in Financial Independence - Scenario 2
What if we decide to work part time once we are financially independent? Let's assume that we are making $20,000 part time at a 40-60 mix. Our total income breakdown would be:
- Mrs. T: $12,005 employment income ($8,000 employment income + $4,005 RRSP income) + $4,800 eligible dividend income
- Tawcan: $16,005 employment income ($12,000 employment income + $4,005 RRSP income) + $7,200 eligible dividend income
The two of us will pay $756 in taxes for a combined taxable income of $40,010. An average tax rate 1.89%! Because our marginal tax rates are so low, we would be getting part of the RRSP withholding taxes back . If the part time income is from our side businesses, we can most likely write off eligible expenses too, meaning we will be paying even less taxes.
Taxes in Financial Independence - Scenario 3
What if we make $40,000 in part time income plus $40,000 in dividend income?
- Mrs. T: $20,005 employment income ($16,000 employment income + $4,005 RRSP income) + $4,800 eligible dividend income
- Tawcan: $28,005 employment income ($24,000 employment income + $4,005 RRSP income) + $7,200 eligible dividend income
In this $80,010 per year income scenario, we would be paying a total of $4,353 in federal and provincial taxes on a $60,010 taxable income. This is an average tax rate of 7.25%. To put into perspective, if Mrs. T and I were to make $32,005 and $48,005 in active income ($80,010 total), we would be paying a total of $12,001 in taxes, or about 15% average tax rate.
As a Canadian, I think it's important to pay whatever amount taxes that we owe to make sure Canada stays great. Social services like health care, schools, public transportation rely on taxes. Therefore I have no problem paying a small amount on our taxable income.
The three scenarios above showed taxes on dividend income can be very minimum if we construct our dividend portfolio properly. It is indeed possible to rely on dividend income alone when we are financially independent. We need to maximize all of our TFSA contribution rooms to take advantage of the tax free dividend income. Since withdraws from RRSP are considered as employement income and taxed at our marginal tax rates, it is more efficient to receive dividend income from taxable accounts.
Moving forward, it is crucial that we construct our dividend portfolio and any working income so they are split roughly equally between the two of us.
Dear readers, what do you think about my assumptions? If you see any holes in my tax calculations and assumptions, I would very much love to hear from you.