How to Pay No Tax on Your Dividend Income - Retire by 40 (2024)

April 15 is closing in fast. This is the tax filing deadline in the United States and it’s usually a painful time of the year for many people. Last year, it took me many agonizing weekends to sort out our tax return. 2014 was more complicated than usual because we sold our 4-plex and did a 1031 rollover. Also, KMP changed to KMI and this caused a huge headache because the tax instructions were very vague. Thankfully, our tax return for 2015 was much less complicated. I’m mostly done and the great thing is we don’t have to pay federal tax on our dividend income. Ahh… I love our dividend portfolio. It requires very little maintenance and our dividend income continues to increase over time regardless of how volatile the stock market is.

Dividend Income

In 2015, we had $10,445 in dividend income. That’s pretty good and I plan to increase it to $11,500 this year. The dividend income is getting more significant and it’s really nice that we don’t have to pay federal taxes on this. Let’s take a closer look at our dividend income and the tax code.

• Ordinary dividends: $10,445
• Qualified dividends: $10,068

The qualified dividends are taxed at the long term capital gain rate. This is really good because the long term capital gain rate is usually lower than the ordinary income rate. Non-qualified dividends are taxed at your ordinary income rate.

As you can see, some our dividends are non-qualified. These are dividend income from REITs, MLPs, tax-exempt corporations, and foreign corporations. In our statement, the following are non-qualified.

• NNN: $273. This is a real estate investment trust.
• OHI: $51. This is also a REIT.
• VLP: $53. This is Vanguard Pacific region ETF.

Anyway, a very small percentage of our dividend income is non-qualified. And we end up paying $43 in tax for this small portion. The vast majority of our dividend income is qualified and we didn’t have to pay any federal tax on it this year. That’s $1,500 in our pocket instead of Uncle Sam.

No tax on dividend income

Everyone who invests in the stock market should know the capital gains are taxed at a lower rate than ordinary income (wage, interest, and earned income). This is good to know because many of us should qualify for the 0% capital gain tax. Here is a 2016 tax table for a quick reference.

The important thing to note here is if you’re in the 10% and 15% tax bracket, then your long term capital gain tax rate is 0%. Isn’t that awesome?

Tax summary

Let’s take a look at the summary of our 2015 tax.

The Adjustments are due to the amount contributed to my i401k and self-employment tax. For deductions, we have mortgage interest, state and local taxes, and some donations.

Our taxable income is comfortably under the 15% tax bracket. In fact, we could increase our dividend income by $30,000 and it wouldn’t increase our federal tax payment. I double checked it in the (affiliate link.) This is why I like doing my own tax. I can plug in different numbers to see how the modifications affect our tax return. It’s great to know we have a lot of headroom for long term capital gain. This knowledge is useful because I will be able to reset the basis on some of my stock investment this year. I can sell some stocks and buy it right back at the same price. Here is an example.

• I purchased 100 shares of XYZ for $10 each in 2014. Cost basis = $1,000.
• I sell 100 shares of XYZ for $20 each in 2016. Long term capital gain is $1,000, but I don’t have to pay any tax.
• I buy back 100 shares of XYZ right away for $20 each. Now my new cost basis is $2,000.

Why do this? If our income increases in the future and pushes us above the 15% tax bracket, then we will have to pay tax on long term capital gain. Gain is sale price minus the cost basis. By resetting the cost basis, we lower the capital gain and we’ll pay less tax. Also, the long term capital gain tax rate may increase in the future.

How to pay no tax on your dividend income

Actually, it is not a bad thing if you’re paying tax on your dividend income. That means your earned income is quite high. Anyway, here is how to pay no taxes on your long term capital gain. You need to push your taxable income into the 15% tax bracket.

• Maximize your deduction and adjustments. Everyone should max out their 401k contribution every year.
• Do your own taxes so you understand the tax code better. Or at least get a good briefing from your tax guy about how to reduce your tax.
• Reduce your taxable income. Rental properties are a great way to do this because you can take depreciation and offset some of your other income. HSA and childcare expenses are also great ways to offset your income.
• Live in a state with no income tax. Don’t forget about state tax. We still have to pay 9% tax on our dividend income to Oregon.
• If all else fail, you can always retire early and reduce your income that way. 😉

Okay, I think that’s enough about taxes. I hope I didn’t put too many people to sleep. I know our editor (Mrs. RB40) will barely be able to stay awake though this post.

Did you finish your 2015 tax return? Do you have to pay tax on your dividend income?

Image credit:by jasoneppink

Disclosure: There is an affiliate link in this article. I may get a referral fee if you sign up or purchase the H&R Block tax software linked above.