For example, qualified dividends are taxed at an effective rate of zero percent for those individuals who are in the 15% tax bracket. The 2015 tax brackets for a couple that is married and filling jointly is posted below (Source: IRS.com):
| Taxable Income | Tax Rate |
| $0 to $18,450 | 10% |
| $18,451 to $74,900 | $1,845.00 plus 15% of the amount over $18,450 |
| $74,901 to $151,200 | $10,312.50 plus 25% of the amount over $74,900 |
| $151,201 to $230,450 | $29,387.50 plus 28% of the amount over $151,200 |
| $230,451 to $411,500 | $51,577.50 plus 33% of the amount over $230,450 |
| $411,501 to $464,850 | $111,324.00 plus 35% of the amount over $411,500 |
| $464,851 or more | $129,996.50 plus 39.6% of the amount over $464,850 |
This is the 2015 tax bracket for a single individual (Source: IRS.com):
| Taxable Income | Tax Rate |
| $0 to $9,225 | 10% |
| $9,226 to $37,450 | $922.50 plus 15% of the amount over $9,225 |
| $37,451 to $90,750 | $5,156.25 plus 25% of the amount over $37,450 |
| $90,751 to $189,300 | $18,481.25 plus 28% of the amount over $90,750 |
| $189,301 to $411,500 | $46,075.25 plus 33% of the amount over $189,300 |
| $411,501 to $413,200 | $119,401.25 plus 35% of the amount over $411,500 |
| $413,201 or more | $119,996.25 plus 39.6% of the amount over $413,200 |
The personal exemption in 2015 was $4,000 per taxpayer. The standard deduction was $6,300 for a single person or $12,600 for a married couple.
Let’s see what this means that a married couple whose only source of income is qualified dividends. Let’s also assume that this lucky couple earns $95,000 in annual qualified dividend income in 2015.
Since their taxable income is less than $74,900, this couple is in the 15% tax bracket. Under the current legislation, individuals in the 15% tax bracket pay zero taxes on qualified dividend income and long-term capital gains.
| Gross Income | $ 95,000.00 |
| Standard Deduction | $ (12,600.00) |
| Personal Exemption | $ (8,000.00) |
| Taxable Income | $ 74,400.00 |
On a side note, using an average yield of 4%, this couple would need a dividend portfolio which is worth somewhere between $2.30 - $2.40 million. Accumulating such a nest egg could very well take years. If they are smart about their spending however, they likely need much less to live off in retirement. This early retiree for example, the famous Mr Money Mustache, lives on less than $25,000/year, which at 4% yield translates into a nest egg worth approximately $625,000. In my case, the annual spending is between $18,000 - $24,000 per year.
If we are talking about a single individual, the maximum amount of qualified annual dividend income that they can earn is “only” $47,750. At an average yield of 4%, this retiree can afford to retire early with a cool $1.2 million.
| Gross Income | $ 47,751.00 |
| Standard Deduction | $ (6,300.00) |
| Personal Exemption | $ (4,000.00) |
| Taxable Income | $ 37,451.00 |
The most shocking thing is that if you also have Roth IRA income, under current legislation none of it would be taxable. So if your Roth IRA generated another $50,000 - $100,000 in annual dividend income, none of that would be taxable either. But you already know that. Perhaps this is one of the reasons why I am maxing out my tax-deferred accounts today, with the intent to slowly converting those dollars into Roth after leaving the rat race, and pay zero taxes in the conversion. The dividend income from my taxable accounts will be tax-free even if it is ridiculously high at $50,000 - $70,000/year. This is much more than I need.
As I mentioned in the beginning of the post, our tax system is set up in a way to provide preferential treatment to providers of capital. Early retirees are indirectly benefiting from this provision, because they are living off their capital.
Relevant Articles:
- Dividends Provide a Tax-Efficient Form of Income
- Taxable versus Tax-Deferred Accounts for Dividend Investors
- How to save over $60,000/year in a Roth IRA
- Roth IRA’s for Dividend Investors
- Health Savings Account (HSA) for Dividend Investors
