There are many ways to achieve financial independence, for me the primary method is through investing in dividend paying stocks. Why dividend paying stocks? Because I like the idea of owning part of the company and having my money working hard for me, generating passive income.
For Canadians like myself, all the different investment accounts fall under two categories – tax sheltered, and non-tax sheltered.
For the average working Canadian, the available tax sheltered accounts are Registered Retirement Savings Plan (RRSP) and Tax Free Savings Account (TFSA). For RRSP, you’re allowed to contribute up to 18% of earned income reported on your tax return in the previous year. TSFA is a powerful savings account started by the Canadian government in 2009. Any Canadian resident, aged 18 and older, is allowed to contribute a limited amount of after-tax money each year and whatever you make in this account is tax free. In 2014 the TFSA limit is $5500.
The non-tax sheltered vehicle is your plain vanilla regular account. All capital gains and dividends are taxed in this account. Having said that, the tax rate is very favourable compared to regular employment income.
My dividend investing approach is quite simple – maximize tax sheltered accounts before contributing anything in regular accounts.
I hold Real Estate Income Trusts (REITs) and other income trusts in our TFSAs. REITs and income trusts do not pay income taxes because they are required to distribute at least 90% of their earnings to their shareholders. A portion of dividends paid by REITs and income trusts may be classified as nontaxable return of capital. This makes calculating the cost basis somewhat tricky. In the case where dividend received is used to purchase additional shares, so called dividend reinvestment plan (DRIP), calculating cost basis for REITs and income trusts can get very complex and confusing. To keep my sanity, I only hold REITs and income trusts in TFSA.
If you hold any US stocks, you’re subject to a 15% withholding tax on any dividends. Because Canada and US signed a tax exemption treaty, this withholding tax is not applicable if you hold US stocks inside RRSP. For this reason alone, I hold US stocks and any American depositary receipts (ADR) in our RRSPs.
The left over money is then invested in regular accounts. I only invest in Canadian dividend stocks that are eligible for the favourable dividend tax credit.
How does this all work when it comes to achieving financial independence? Withdraw from RRSP before the age of 71 will trigger unfavourable taxes. By the end of the year in which you turn 71, you will also need to convert RRSP into one of the three options – annuity, Registered Retirement Income Fund (RRIF), or collapsing the RRSP. Since age 71 is over 35 years away for me, I don’t plan to touch our RRSP accounts and make a decision on our option until much later. The key contributor to my financial independence will be TFSA and regular accounts. Although TFSA contribution limit is relatively low, with the combination of yearly contribution and the compounding power of DRIP, I’m aiming to have our TFSA’s growing very nicely in the next decade. Receiving sufficient dividends to cover expenses is only part of the equation to financial independence. The other part of the equation is frugal living and keeping expenses low. I will discuss these topics in different blog posts.