by FrugalTrader on October 14, 2009
There are many (legal) tax strategies out there to minimize tax owed to the government. For instance, say investor Derek is a BC resident and fortunate enough to have a large portfolio of dividend payers that provides his sole source of income of $70,000. According to tax tables, Derek should be able to file his income tax and pay $0 to the government due to the dividend tax credit .
Sounds like a great deal, but the government still wants their cut, which is why the Alternative Minimum Tax (AMT) was created. In this situation, both the AMT and the regular income tax must be calculated, with the higher of the two paid as income tax for the year.
How To Calculate AMT?
This is the basics of how to calculate AMT from the kpmg tax planning book for 2009,
- Calculate taxable income after all deductions for regular tax purposes.
- Add back the deductions not allowed under AMT – losses from tax shelters, losses from partnerships, interest expenses, employee relocation, 60% of amounts claimed under employee stock option deduction.
- Add 60% of the untaxed half of capital gains.
- Deduct gross up of dividends – only actual dividend amount is used for calculations, not the grossed up amount.
- Deduct $40,000 – The 2008 AMT exemption
- Multiply by 15% (federal tax) for 2008.
- Deduct Personal Credits – basic personal amount, age credit, disability, cpp contributions, EI premiums, tuition, education, medical and charitable. Do not deduct, investment tax credits, spousal amount, tuition credit transferred from a child, dividend tax credit (and more).
- If the result is higher than your federal tax calculated normally, then AMT must be paid.
- Provincial AMT is then calculated by multiplying the above AMT amount by a provincial AMT rate (varies by province).
An Example of AMT
Going back to our BC investor Derek that made $70,000 from dividends, he would actually have to pay tax. How much?
To calculate Derek’s income tax using regular rules. he would owe $0 in tax due to the dividend tax credit. However, using the AMT calculations, he would owe:
- $70,000 (dividend income) – $40,000 (amt exemption) = $30,000 x 15% = $4,500 – basic personal amount (
$1500) = $3,000 + the provincial AMT amount (up to 50% of federal amount).
In my example above, it showed an investor making $70,000 in dividends as their sole source of income. In terms of taxation, the investor went from owing $0 in tax to at least $3,000 to the federal government (not including provincial government) due
to Alternative Minimum Tax. To put this in perspective though, assuming an average dividend of 4%, the portfolio size would be around $1.75 million so I’m sure the investor isn’t feeling too much pain.
There is a bright side though, because of the AMT exemption of $40,000 and basic personal amounts, most provinces will allow up to $50,000 in dividend income (as your only source) while paying very little tax (if any).
Disclaimer: I’m not a tax pro, this post should be used for informational purposes only. Please consult your tax accountant if you think that alternative minimum tax applies to you.
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In addition to “regular” type dividends – i.e. your example that the investment portfolio would be 1.75 m, don’t forget that many small business owners also choose dividend income rather than salary. Business owners need to keep in mind AMT, though the tax bite is significantly smaller!
$3k tax paid on $70k income. Pretty darn favorable still.
Does the taxation of dividends change if you have other large sources of income? Say you have $50k in rental, interest, and other + $70k in dividend income.
How would this apply to me? I’m employed as a contractor in the IT field. I earned about $12,000 in salary in the early part of the year before switching to contracting (via my numbered corporation). To date this year I’ve earned approx $54,000 in income via my corporation, this should end up in the $75-80k range by the end of the year. My accountant has indicated he’d use dividends to allocate the income we use as a family, but he’s never mentioned this before. Is this something I should be concerned about? Especially going forward next year as my entire income should be coming through my corporation and will likely be higher as well. Thanks to anyone who has advice
Thanks for the info guys. Seems very unlikely that the only source of income would be dividends if you had >$1.75M in assets. In my own planning, dividends play a significant role, as does real estate, interest, and other income.
Seems the dividend route is most advantageous only if you are 100% dividend income (although as you state FP), 20% is a reasonable taxation rate for these income levels.
Sorry for the lack of response guys, work has me tied up! However, it looks like questions are in good hands, thanks for the responses!
Mike, I’ve written a few articles regarding taxation of private corporations, check them out: