Dividend Investing Perfected with Self-Made Dividends (Canadian Financial Summit 2023)

In the vast landscape of personal finance, dividend investing has carved out a significant niche. 

Whether you’re browsing through countless blogs or hearing investment advisors champion its benefits, it’s clear that dividend investing is a popular choice, especially with the FIRE (Financial Independence, Retire Early) community.

However, a closer look reveals that almost all the advantages claimed for dividend investing are not actually true.

In this blog post, YouTube video and podcast episode with Barry Choi, we’ll fact-check the advantages of dividend investing, explain how it is a brain fart, and introduce an alternative that is better in every way: Self-Made Dividends.

You’ll learn:

• Why is dividend investing so popular today?
• What are the advantages of dividend investing?
• Why is tax on dividends a weird formula?
• Fact Check: Are the advantages of dividends true?
• What are the problems with dividend investing?
• How can you perfect dividend investing?
• What are self-made dividends?
• How are self-made dividends taxed?
• Head-to- head: Self-made dividends vs. ordinary dividends.
• Life of self-made dividend investor vs. ordinary dividend investor.
• Why are self-made dividends better than ordinary dividends in every way?
• Why are self-made dividends a perfect fit for your life?

Why Is Dividend Investing So Popular Today?

1. Low Interest Rates: With interest rates at historical lows, many are on a quest for yield.
2. High Cost of Living: As expenses rise, supplementing one’s income becomes essential.
3. The FIRE Movement: Many seek early retirement through careful financial strategies.
4. Post-COVID Reflections: The pandemic prompted many to rethink their work-life balance and income strategies. What would it take to stay home permanently?
5. Loss of Income from COVID: People who are self-employed may have experienced a loss of income during this time. 
6. Baby Boomers: As this generation approaches retirement, the need for reliable income streams has become more pressing. They are wondering how to set up their retirement income.

Advantages of Dividend Investing (Claimed by Dividend Investors)

1. Get paid to wait.
2. Inflation hedge – rises over time, unlike fixed income.
3. Lowest tax rates.
4. You can withdraw $68,000/year with no tax.
5. Superior returns.
6. You keep your shares – Income. Keep your “principal”.
7. You can watch your dividend income rising as you get closer to retirement.
8. Passive income – Enhance your lifestyle or reinvest.
9. Take advantage of corrections & bear markets.
10.  Dividend growth compounding.

However, it’s crucial to scrutinize these claims and understand the underlying complexities.

Why is tax on dividends a weird formula?

The taxation of dividends can be perplexing. 

1/ It can be integrated with corporation tax.

2/ Gross-up of 38%

• $10,000 dividend = $13,800 taxable income
• Pay tax on $13,800 at your marginal tax rate.
•  Approximate before tax income of corporation that paid dividend.

3/ Dividend tax credit

• 15% of the grossed-up dividend.
• 15% of $13,800 is $2,070.
• Approximate the tax the corporation paid.

4/ This is “eligible dividends” from public companies. Stock market.

•  “Ineligible dividends” from private companies is different.

What are the problems with dividend investing?

Despite the perceived advantages, dividend investing has its pitfalls:

1/ Pay tax on the income, even if you don’t need it. E.g., saving for retirement.

2/ Companies control the amount.

1. They might not increase dividend, could stop it, etc.

3/ Hard to get the income that you want. 

4/ Companies control the timing of dividends.

1. Hard to make a regular monthly income. Pay quarterly (mostly).

5/ Taxable income is “grossed up” to 138% of cash income.

1. Reach higher tax brackets & clawbacks with less cash income.

6/ High clawbacks of government benefits – E.g., 69% clawback of GIS!

7/ Diversification is limited.

1. Mainly utilities, telecom, consumer staples, energy & financials, not tech.

8/ All Canadian investments. Must invest 100% in Canada to get lower tax rates.

1. Home country bias.

9/ Choose stocks based on dividends, not investing fundamentals.

1. Fundamentals, like risk & return and growth potential.

10/ Limited choice for higher dividends. Often over-valued. 

How can you perfect dividend investing?

Self-made dividends. Dividend investing perfected

So, how can investors refine their approach? The answer lies in Self-Made Dividends. 

What Are Self-Made Dividends?

• Simply sell a bit of your investments: This strategy involves selling a portion of your investments to generate cash flow instead of relying solely on dividend payments.
• Can be every month
• You choose the withdrawal amounts: You can dictate how much to sell and when. 
• Tax Efficiency: Only pay taxes on realized capital gains, not on income you don’t need.
• Can be automatic with some investments. E.g. Mutual Funds
• Flexibility: Adjust your cash flow according to your personal needs.

For example, if you invest $500,000 that grows to $1 million and want an annual cash flow of $40,000 (following the 4% rule), selling $3,333 monthly could be a strategic move. This would yield a tax liability of just $10,000, compared to significantly higher tax implications associated with ordinary dividends.

How are self-made dividends taxed?

Partly your capital & partly capital gain.

If you invested $500K that grew to $1 million:

• You want cash flow of $40,000/year (4% Rule).
• Sell $40,000 = $3,333 every month.
• Half is your capital: $20,000 is tax-free.
• Half is the growth: $20,000 is a capital gain.
• 50% of capital gains are taxable: $10,000 taxable income.

Cash flow of $40,000:

Self-made dividends: $10,000 is taxable.

Ordinary dividends:   $55,200 is taxable (with gross-up).

Fact Check: Are the advantages claimed for dividends true?

1. F: Get paid to wait.

2. F: Watch your dividends rise as you get closer to retirement

3. F: Passive income – Enhance your lifestyle or reinvest.

4. T: Inflation hedge – rises over time, unlike fixed income.

5. F: Lowest tax rates.

6. Depends: You can withdraw $68,000/year with no tax.

7. F: Superior returns.

8. F: You keep your shares – Income. Keep your “principal”.

9. F: Take advantage of corrections & bear markets.

10. F: Dividend growth compounding.

Fact Check: Advantages 1-3:

1. F: Get paid to wait.

2. F: Watch your dividends rise as you get closer to retirement

3. F: Passive income – Enhance your lifestyle or reinvest.

1. F: Get taxed to wait.

2. F: Taxed on dividends you don’t need before retirement.

3. F: Taxable income you may not need.

a. Reinvest is the same as not having a dividend. 

These 3 are disadvantages.

• You are taxed on the income, even if you don’t need it.
• You need cash flow, not income. Income is taxable cash flow.
• Cash flow only when you need it.

Fact Check: Advantage 4:

4. True: Inflation hedge – rises over time, unlike fixed income.

• True for all stock market investing.
• 200-year return of S&P500 is 7%/year + inflation.
• Big problem for fixed income.
• The reason seniors with GICs & bonds complain about being on a “fixed income”.
• Cost of living rising every year.
• Fixed income is a pay cut every year.

Fact Check: Advantage 5:

Fact Check: Advantage 6:

Earn $68,000 with no tax:

• Tax is not zero.
• You pay Alternative Minimum Tax (AMT) & some provincial tax.

$65,000 dividend in Ontario (2022):

• Pay total $2,983 in tax = 5%.
• No federal tax.
• Pay $1,590 of federal AMT. – Federal AMT starts at $55,000 of dividends.
• Pay $643 of provincial AMT.
• Pay $750 provincial tax for Ontario Health Premium.

Starts at $20,000.

Only if you are single: Spouse loses 28% in spousal credit.

Both only dividends: AMT starts at $2,800/year.

–          Only if you are under age 65:

 69% clawback of GIS!

Guaranteed Income Supplement – Government pension.

–          Not for RRSP.

Fully taxed when you withdraw.

–          Not if investments are in a corporation.

Passive income taxed at 50% in corporation.

Not true for retirement income.

Fact Check: Advantage 7:

Returns are NOT superior.

• Dividend investing vs. index or All Star investing.
  • Dividends are 100% Canada. Returns in Canada are much lower than global or US. This is the main factor in comparing returns.
  • Index or All Star is global or US investing.
• Comparing within one country:
  • Charts vary depending on time period.
  • Less volatile in both directions.
  • Excludes some loser stocks & the top growth stocks.
• Benefitted from “Bond Bubble” 1982-2020.
  • Interest rates fell from 20% to 1%.
  • Falling interest rates benefits “fixed income”.
  • Not likely to ever happen again.

Index or All Star investing beats dividend investing.

Invest globally. Not 100% in Canada.

Invest based on Fundamentals – Not for dividends.

Invest for highest, reliable long-term total return after tax.

Smart investors never pay extra for dividends.

RRSP/TFSA: Dividend & index investing are similar.

Dividends stay invested & are irrelevant.

Dividend investing is just a smaller universe:

75% of S&P500 pay dividends.

53% of global stocks pay dividends.

95% of TSX60 pays dividends.

Canadian dividend funds almost identical to index.

Warren Buffett: Be “agnostic about dividends”. 

Fact Check: Advantages 8-10:

Dividends are withdrawals from investments.

8. F: You keep your shares – Income. Keep your “principal”.
   • There is no “principal” with equity investing.
   • A dividend is a withdrawal from your investments.
9. F: Take advantage of corrections & bear markets.
   • Reinvesting dividends is NOT buying low.
   • It is both a withdrawal & a new investment.
10. F: Dividend growth compounding.
    • Reinvesting dividends is NOT new money.
    • No dividend is also growth compounding.

Logic error of dividend investors.

1.       Dividend vs. selling shares for same amount:

Both are withdrawals from your investments.

“Ex-dividend date”: Stock goes down by the amount of the dividend.

Dividend vs. selling shares – both are withdrawals:

Stock $10/share. Pays $.50 dividend. Shares drop to $9.50/share.

You have share worth $9.50 + $.50 cash from dividend = $10.

Dividends do not change your net worth.

If you sell $.50, you have shares worth $9.50 + cash of $.50 = $10.

Selling the same amount is the same as a dividend (taxed less).

2. Reinvest dividend vs. no dividend – Both you stay invested.

Use $.50 dividend to buy more shares.

You have 1.05 shares x $9.50 = $10.

No dividend: 1 share x $10 = $10.

• No dividend is the same as reinvest (taxed less).

Dividends are NOT new money.

• Companies can do 4 things with their profits:
  • Reinvest in the business.
  • Buy other companies.
  • Buy back their own shares
  • Pay dividends.
• All 4 uses of cash contribute to total return.
• If companies did not pay dividends, they could grow faster by reinvesting.
• Many companies are doing share buy-backs instead of paying dividends today.
  • This is more tax-efficient than paying a dividend.
  • Investors own a larger portion of the company.
• Warren Buffett’s Berkshire Hathaway does not pay a dividend:
  • It could, because it generates tons of cash.
  • He allocates capital more effectively, so he thinks investors are better off leaving money reinvested.

How can you perfect dividend investing:

Self-made dividends. Dividend investing perfected.

Advantages of self-made dividends vs. ordinary dividends:

1.   You decide the amount of dividend you receive.

2.   You can start, stop and change the dividend any time you want.

3.   You are not forced to pay tax on dividends when you don’t need the cash.

4.   You can invest properly based on risk/return, instead of chasing yield.

5.   You can avoid buying expensive investments to get a higher dividend.

6.   You can properly diversify globally, instead of having all your investments in Canada.

7.   For seniors, the clawback of government benefits from ordinary dividends is 5-6 higher than on self-made dividends.

8.   You pay less tax than on ordinary dividends (or sometimes no tax).

9.   Lowest-taxed type of income is deferred capital gains.

10.   Gives you cash flow, not income. Income is taxable cash flow.

Fix ALL the problems with dividend investing.

1. Pay tax on the income only if you don’t need it.
2. You control the amount.
3. Easy to get the income that you want. J
4. You control the timing of dividends.

•        Easy to make a regular monthly income.

5. Taxable income is not grossed up. Only 50% of the capital gain.

•        Reach higher tax brackets & clawbacks with far higher cash income.

6. Very low clawbacks of government benefits. – E.g., about 12% clawback of GIS.
7. Diversification is unlimited.
8. Invest globally.

•        No home country bias.

9. Choose stocks based on fundamentals.

•        Fundamentals, like risk & return and growth potential.

10. Unlimited choice for higher dividends. 

Life of a dividend investor.

• Saving for retirement:
• Dividend investor proudly builds higher dividends. 
• Reinvests dividends. Don’t need the cash flow.
• Pays tax on dividends every year.
• Tempted to spend some of the dividends, so less for retirement.
• Investments 100% in Canada.

I often read posts on dividend blogs about being proud to achieve a certain amount of dividends. “I now get $2,500/month in dividends!” I am tempted to comment, “Sorry to hear that. You are not retired and don’t need the cash flow. How much unnecessary tax are you paying?” I usually resist posting.

• Retirement or living off dividends:
• Income usually too low for desired lifestyle.
• Most dividend stocks pay less than 4% Rule.
• Income goes up & down. 1 high month & 2 low months.
• No control on amount or timing of dividend income.
• Tempted to “chase yield” or buy “high dividend stocks”:
• Usually overvalued or low growth.

Life of a “self-made dividend” investor.

• Saving for retirement:
• Dividend is zero while building up retirement nest egg.
• Invests globally or US.
• Invests based on fundamentals of risk & return and growth.
• Retirement or living off dividends:
• Decide on exact desired income. E.g., 4% Rule.
• Start immediately.
• Every month exactly the same income.
• Full control of the exact amount & timing.
• Reduce easily if you have other income. E.g., side hustle / PT job
• Increase easily if you want more. E.g., big trip.

Why are self-made dividends a perfect fit for your life?

• Perfect fit for your retirement plan:
• 0% dividends while saving for your retirement.
• Start the exact retirement income you want.
• Choose a sustainable income. E.g., 4% Rule.
• Adjust your retirement income to stay sustainable.
• Adjust your retirement income whenever you want.
• Self-made dividends: perfect fit for your desired lifestyle

Am I recommending to avoid dividends? No.

Smart investors never pay extra for dividends on their investments. Warren Buffett says investors should be “agnostic about dividends”.

Any equity investing, you will get some dividend stocks. Many of the best companies pay dividends. Some of the best companies do not pay dividends.

Invest based on fundamentals like risk/return and growth potential.

Invest for the highest, reliable long-term total return after tax.

The Advantages of Self-Made Dividends

1. Control Over Withdrawals: You dictate the amount and timing.
2. Tax Efficiency: Only pay taxes when you need the cash.
3. Better Investment Strategy: You can invest based on fundamentals, not just on dividends.
4. Global Diversification: Avoid the pitfalls of home country bias by investing in a broader array of assets.
5. Lower Clawbacks: Government benefits are generally affected less by self-made dividends than by traditional dividend income.

The Life of a Self-Made Dividend Investor vs. an Ordinary Dividend Investor

While traditional dividend investors may feel locked into the whims of companies and taxation structures, self-made dividend investors enjoy greater freedom and flexibility. They can align their investment strategies with their life goals, ensuring that their investments work for them rather than the other way around.

Embrace Self-Made Dividends

In the complex world of dividend investing, understanding the advantages and limitations is crucial. By adopting the self-made dividend strategy, investors can take control of their cash flow, enhance tax efficiency, and align their investments with their broader financial goals. As you navigate your investment journey, consider how self-made dividends might fit into your strategy, allowing for a more personalized and effective approach to achieving financial independence.

Ed