In my last post, I went over the basics of the tax system and the different types of tax-deferred and tax-sheltered accounts. These are the cookie-cutter techniques available to middle-class people. Armed with the correct knowledge and how to apply it, you are now accelerating on your journey to financial independence. But, what you really want to know is how to go from middle class to rich, right?
Well, now its time to turn it up a notch and see if you can handle the increased speed! I will discuss the various types of income. I will also discuss how each is taxed. If you have internalised the idea of a rich mindset, then understanding these concepts is critical to your success.
Different Income Types
In your working years, the vast majority of your income is employment income which people are most familiar with. This income is then subject to federal and state taxes, the details of which I shared extensively in the last post.
In my earlier post about financial independence, I mentioned that rich people earn a large proportion of their income through investments, rather than direct employment. The two major types of investment income are:
1. Dividend income – income paid to you by a company whose shares you own.
2. Capital gains income – income generated through sale of stocks which have appreciated in value.
The tax treatment for investment income is significantly different (and better) than for ordinary employment income. This is a very important principle that you need to understand and internalize.
I am going to explain in detail, taking into account the differences in US and Canada. Also, do note that there are other types of passive income as well such as rental income. However, for most people, employment and investment income are the most relevant and that is where I will focus on.
USA
As of 2023, these are the federal dividend and capital gains tax brackets:
Note that these brackets apply for qualified dividends only. You can refer to this article on the details of what qualified dividends are. This is a practically a non-issue in most cases as most US corporations pay qualified dividends. If you have held the underlying shares for 60 days or more, the paid-out dividend is qualified. If it does not meet the 60-day holding criteria, it is considered as an ordinary dividend and is treated as employment income.
The same treatment, although in a slightly different manner, is applied to capital gains. Long-term capital gains are those which are realized from stocks held for more than 365 days. Those gains are preferentially treated at the same rate as qualified dividends. Short-term capital gains are those which are realized from stocks held for 365 days or less and are treated as employment income.
Right off the bat, you can see the massive advantage of investment income over employment income – a single person can earn up-to $44K in qualified dividends and long-term capital gains with tax rate of 0%. This in sharp contrast to a single person with $44K in employment income with an effective tax rate of 11.8% (as of 2023). With higher incomes, the differences become even more!
Canada
In Canada, dividends are taxed somewhat differently. Dividends issued by a Canadian corporation to a resident of Canada are known as eligible dividends. The dividend tax calculation is somewhat lopsided and involves grossing up the eligible dividend amount by 38% (known as the gross-up amount), adding it to your taxable income and multiplying that amount by 15.02% (eligible dividend tax credit rate). To keep it really simple, in the absence of any other forms of income, a single person can earn up-to $53,359 (as of 2023) in eligible dividend income without paying any taxes. For non-eligible dividends, the dividend tax credit rate is lower which results in somewhat higher taxes.
Capital gains in Canada are treated differently as well. Short-term and long-term gains have no distinction between them. Also, taxes are levied only on 50% of the capital gains.
In Canada, eligible dividends are better than capital gains in terms of taxes. For example, a single person with a combined investment income of $54K ($34K in eligible dividends and $20K in capital gains) has an effective tax rate of 2.8%. Another single person with the same combined investment income of $54K ($24K in eligible dividends and $30K in capital gains) has an effective tax rate of 4.2%. However, in both cases, it is way better than a single person with $54K in employment income with an effective tax rate of 15% (as of 2023). Similar to the US, with higher incomes the differences become even more.
So, How Do You Go From Middle Class To Rich?
In my last post, I mentioned that your goal during employment years must be to fill your tax-free swimming pool as much as possible. After understanding differences in taxation on different types of income, you should be able to see the reason why. By shoveling your money into your tax-deferred and tax-sheltered accounts (and hopefully being in an envious position where you enough left over to sock it in a taxable investment account), you are now making the structural shift into investment income which allows your net worth to grow with little or no effort from your part.
In other words, you are transitioning from the middle-class to the rich! Yes, its that simple! It does not require you to win a lottery, become a sports superstar or be a successful entrepreneur. The best part is it is doable by everyone. However, it does require character traits such as discipline, patience and consistency.
That’s about it. Hopefully, now you have a sound understanding on how taxes work and what ways you can legally use to reduce your tax bill. You can also appreciate how rich people legally pay little or no taxes.
Yours truly,
Rizwan.