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Investor Education How to earn $52,000 tax free – no offshore account required

Interested in making tens of thousands of dollars a year without paying any tax?

Sure, you could open a Swiss bank account or stash your funds in the Cayman Islands. But say you want to keep everything on the up and up and don’t relish the thought of doing jail time.

Well, today I’m going to show you a perfectly legal way to earn more than $50,000 a year without paying a dime to the Canada Revenue Agency.

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The secret? Invest in dividend stocks.

Most investors understand that dividends are taxed at significantly lower rates than interest or employment income. The tax break arises because eligible dividends from publicly traded Canadian corporations benefit from the dividend tax credit (DTC).

What many investors may not understand is that the DTC, when combined with the basic personal credit available to all Canadians who pay income tax, can slash the tax on dividends to zero – even when dividend income is well into five figures.

The amount of dividend income you can earn tax free depends on your province of residence. The best places to earn tax-free dividends are British Columbia, Alberta, Saskatchewan, Ontario and New Brunswick, where up to $52,069 of eligible dividends can be received in 2019 without incurring tax, according to KPMG’s Tax Facts. This assumes the taxpayer has no other sources of income.

Let’s look at an example.

Say you live in Ontario and, after a few decades of hard work and saving, you’ve built a nest egg of $1.3-million. You decide to retire and invest the money in a portfolio of dividend stocks yielding an average of 4 per cent. Your portfolio would generate annual dividend income of $52,000, which we’re assuming is all received in a non-registered account.

When it’s time to file your tax return, the $52,000 would be listed on your tax slip as the “actual amount of eligible dividends." To understand how dividend taxation works, however, we need to look at two other important numbers on your tax slip: the “taxable amount of eligible dividends” and the federal “dividend tax credit for eligible dividends."

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The taxable amount of dividends is calculated by multiplying the actual amount of dividends by a “gross-up” factor of 1.38. This produces taxable dividends of $71,760. Why are dividends grossed up, you ask? Well, dividends are paid out of a corporation’s after-tax income. The purpose of the gross up is to roughly estimate the amount of pre-tax income the company (or, in this case, companies) would have to earn in order to pay you the dividend.

But wait. You only received $52,000. It wouldn’t be fair to tax you on $71,760, would it? After all, the company has already paid corporate tax on those earnings.

Enter the dividend tax credit. As the name implies, the DTC effectively gives you “credit” for the corporate tax already paid. The federal DTC is about 15.02 per cent of the grossed-up dividend amount. Provinces also kick in their own DTCs; in Ontario, the DTC is 10 per cent.

In our example, applying these DTC rates to the grossed-up dividend of $71,760 produces a federal DTC of $10,778 and provincial DTC of $7,176. These amounts, combined with a federal tax credit of $1,810 (15 per cent of the basic personal amount of $12,069), reduce your taxes to zilch. (Before any credits, $71,760 of income would attract tax of $16,858.)

You’ll still have to pay an Ontario health premium of $600 – but that’s it. There are no other taxes to pay.

The above numbers (which I produced with the help of a detailed Canadian tax calculator at TaxTips.ca) are for an individual who claims only the DTC and the basic personal amount. For individuals who qualify for other credits – such as the age amount or the spousal amount – it is possible to receive more than $52,000 in dividends tax free, says Dorothy Kelt of TaxTips.ca.

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Granted, it’s unusual for someone to receive only dividend income. Most people have other sources of income, such as a job, a pension or withdrawals from a registered retirement income fund. But even in such cases, dividend income is still taxed very favourably.

For that reason, “Canadian dividend-paying stocks are the best thing to have in a non-registered account,” Ms. Kelt says. Aside from the tax benefits, dividend stocks are a much better long-term investment than interest-bearing securities that don’t even keep up with inflation, she says.

So, if you want to keep your taxes low, don’t rush out and open an offshore account. Consider investing in dividend stocks instead.

E-mail your questions to jheinzl@globeandmail.com.

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