When my family was young, I bought dividend stocks to provide a stream of income in case I was out of work for some reason. With my daughter just finishing her sophomore year of college, I no longer have to worry about accessing the potential income stream I’ve created. (The dividends were largely reinvested anyway.) I’ve done the heavy lifting, but now I’m making some adjustments that have both reduced the taxes I pay and increased the income hitting my accounts. You may want to know more about the somewhat obscure rule that allows me to achieve this.
The most important accounts for saving taxes
If you’re looking to avoid paying taxes on dividend income, a tax-advantaged retirement like an IRA will be your friend. Of the options available, a Roth IRA is probably the best choice. Although you must put after-tax money into a Roth, dividends and capital gains in the account accumulate tax-free. And more to the point, since you already paid taxes on the money that went in, you don’t have to pay taxes on the money you end up taking out.
Simply put, dividend stocks in a Roth IRA or other Roth account – a Roth 401(k), for example – can provide you with ongoing tax-free income in retirement. Loading a Roth with high-yielding dividend stocks can be a good long-term choice from a tax perspective. But there are some nuances here that you need to consider before doing anything.
For example, I started by moving real estate investment trusts (REITs) from taxable accounts to my Roths. Dividends from REITs are taxed at ordinary income tax rates, so they have greater tax consequences than those from a typical corporation. Moving them into a Roth before other dividend stocks makes perfect sense.
My latest tax measures concern Canada
But there is another small loophole in the tax code that investors should be aware of, and that would be in the Canadian tax code. I own Enbridge (NYSE:ENB), Toronto-Dominion Bank (NYSE:TD)And Bank of Nova Scotia (NYSE:BNS). All three are Canadian companies listed on American stock exchanges. Holding them in a taxable U.S. brokerage account requires payment of Canadian withholding taxes. But Canada doesn’t require withholding tax if Canadian dividend-paying stocks are held in a tax-advantaged U.S. retirement account like a Roth.
Basically, I get 15% more income just by putting these three stocks in a tax-advantaged retirement account. To be fair, I purchased Bank of Nova Scotia in a Roth account, but chose to move Enbridge and Toronto-Dominion from taxable accounts to my Roth accounts.
This required selling the shares in the taxable account and buying them back into a Roth. There are clearly capital gains issues to consider, but I was able to offset the gains I faced by capturing losses in other stocks I owned. So overall these measures ended up being a failure, in tax terms, with the net benefit being an increase in income (because I no longer pay Canadian taxes before receiving the dividend), a reduction of my current taxes (because I no longer pay taxes in Canada before receiving the dividends). U.S. dividend taxes each year), and the benefit of creating a long-term tax-free income stream when I eventually retire.
There are a few caveats. First, income from dividend-paying stocks that you put in a tax-advantaged account can’t really be drawn without penalty until you reach retirement age. There is some wiggle room with a Roth, but it gets complicated. It’s always best to only own dividend-paying stocks that you consider to be long-term holdings in an IRA of any type. And you clearly need to be able to survive without the income from these dividends if you haven’t yet reached retirement age.
The next issue you need to consider before placing Canadian dividend stocks in an IRA is your broker. The tax advantage is only visible if your broker completes the necessary documents for its realization. My broker is large and well known, and he took care of the paperwork. You’ll probably want to call your broker to make sure you can avoid taxes on Canadian dividends before you start buying such stocks in your IRA, just to make sure. Be prepared for a long call, though, as this question is likely more complicated than a front-line employee can cover.
Small actions add up to big savings
From a big picture perspective, moving Enbridge and TD Bank to a Roth account was not a major change. But the long-term impact will, over time, turn into a huge benefit. Saving the 15% Canadian dividend tax, paying no US taxes on dividends, and possibly receiving tax-free income in retirement will definitely improve my long-term returns. And it goes to show that a little knowledge can go a long way when it comes to managing your own investments.
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Reuben Gregg Brewer holds positions at the Bank of Nova Scotia, Enbridge and the Toronto-Dominion Bank. The Motley Fool has positions with and recommends Enbridge. The Motley Fool recommends Bank Of Nova Scotia. The Motley Fool has a disclosure policy.
Thanks to 1 Obscure Rule, I’m Making More Money From These 2 Dividend Stocks was originally published by The Motley Fool
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