Self-Made Dividends – Dividend Investing Perfected

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Dividend or income investors, here are the fundamental facts on how to save tax.

Would you like to receive dividends of any amount you want from your non-registered investments, and pay less tax than on ordinary dividends? You can easily do this with a little planning and proper understanding of investments.

Self-made dividends are a simple concept with profound benefits. Dividend investing has been very popular recently, but self-made dividends are better than ordinary dividends in essentially every way. They have lower taxes, better investment options, and are much more flexible for giving you income when you need it.

When clients retire and I setup the retirement income they want, self-made dividends make the process easy and usually save a lot of tax.

Self-made dividends are a perfect fit for a retirement plan. They fit your life.

Prefer an overview? Like videos? Check out our whiteboard video, or read the full post below!

What are self-made dividends?

Self-made dividends are simply a strategy to sell some of your investments each month. This can be automated with mutual funds or segregated funds, and is called a “SWP” (systematic withdrawal plan). With other investments, just sell investments to give you the cash flow you need.

You decide how much you want to sell every year. It is advisable, though, that you withdraw an amount that is sustainable long term.

When you sell an investment, you pay tax on the capital gain, to the extent that your investment has gone up. Unless you have owned an investment many years and it is up a lot, the portion that is taxable is low.

How do self-made dividends work in a retirement plan?

Depending on how you invest, withdrawing between 3% to 5% of your investments per year is generally considered sustainable long term. In my own research, I found that withdrawing 4% per year from an equity portfolio and increasing it by inflation provided a reliable retirement income virtually 100% of the time in the last 150 years. For a more conservative portfolio that includes bonds, 3% per year is a better choice.

Let’s say you have $1 million in investments. You consider 4% per year as a sustainable withdrawal, so you withdraw $40,000 from your investments every year.

You can increase or decrease this any time you want. It is completely flexible.

Now let’s say you accumulated the $1 million by investing $500,000 over the years. Your investments have doubled. *

When you sell $40,000 for this year’s retirement income, only the half that is the gain is a capital gain, which means you have a $20,000 capital gain. Only 50% of capital gains are taxable, so you have a $10,000 taxable capital gain.

If you had received an ordinary dividend, the entire $40,000 would be taxable. But since you have a self-made dividend (sold $40,000 of your investments), only $10,000 is taxable.

In your retirement plan, it is actually cash flow that you need, not income. Income is taxable. Cash flow is sometimes taxable and sometimes not. Self-made dividends give you the cash flow you want in your retirement, while having only a small portion of it be considered taxable income.

While you are saving for retirement, normally you should choose a zero self-made dividend until you need the cash. Why pay tax on a withdrawal you don’t need? Then when you retire, flip the switch and turn on your self-made dividend the day you want the cash. Choose any amount, but 3-5%/year should be sustainable long term, depending on how you invest.

What is the big picture?

Dividend investing is part of the “search for yield” of many investors today. Interest rates are too low to grow wealth. Equity investors are fearful ever since the crash in 2008, so they want dividends now instead of waiting for growth.

The search for yield has made stocks with high dividends very expensive, even though most of these stocks have little or no growth, or are even shrinking. It has created a “dividend bubble”.  Just like the technology bubble in the 1990s, dividend investors seem to think valuation does not matter.

If you are investing in expensive companies with low growth, you should assume a risk of a major downturn and a low return long term. What will happen to dividend stocks whenever interest rates rise?

Dividend investors often end up with very poor diversification for several reasons:

  1. They often invest entirely or mainly in Canada, since tax on Canadian dividends are taxed at lower rates. Canada is only 3% of the world’s stock market and most of the world is growing faster.
  2. They often heavily over-weight the sectors that have the highest dividend rates, such as utilities, telecom, consumer staples, energy & financials. There are many other sectors, most of which have faster growth.

Self-made dividends avoid all these risks.

Self-made dividend investors can invest properly based on risk/return, quality and diversification. Of course, most companies in the stock market pay dividends, so any diversified portfolio probably has stocks that pay dividends. However, the dividend rate does not drive the investment bus.

Why are self-made dividends better than ordinary dividends?

Self-made dividends are taxed at lower rates. In addition, dividends have 2 big risks – over-valuation and lack of diversification. Self-made dividends avoid these risks and have a list of major advantages:

  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):

Self-made dividends are essentially taxed as deferred capital gains, which are the lowest taxed form of investment income. This article explains it: https://edrempel.com/lowest-taxed-type-investment-income-6-ways-invest-deferred-capital-gains/ .

Tax on self-made dividends start at zero. When you sell a bit of an investment you just bought, there is no gain yet, so the entire self-made dividend is tax-free.

The tax rate normally rises to about half the capital gains tax rate after about 10 years (when your investments have doubled) and about 2/3 the capital gains tax rate after 15-20 years (when your investments have tripled). * They may get close to the capital gains tax rate after 30-50 years.

Here are the tax rates:

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Ordinary dividends are a disaster for seniors!

For seniors, ordinary dividends can be a disaster! Many government benefits are clawed back based on income. Ordinary dividends are “grossed-up” on your tax return by 38%, so 138% of the dividend is considered income. All clawbacks apply to 138% of the dividend.

For example, the GIS program for seniors is clawed back at 50% of your income. For dividends, the taxable income is 138% of the dividend, and 50% of that is clawed back. Dividend investors have a 69% clawback on top of income tax!

In addition, many government benefits and subsidies for seniors are income-tested. The annual deductible on drugs, rent in many retirement buildings and many government benefits are all income tested. In every case, the income test applies to 138% of the dividend. It is not uncommon for low income seniors to pay more than 100% of their dividend between clawbacks, lost benefits and income tax.

For self-made dividend investors, between 0% and 50% of the self-made dividend is considered income, so the 50% GIS clawback is only 0%-25%. Typically, the clawback is about 12% (assuming your investments have doubled over the years).

In short, many seniors should avoid dividend investing after age 65. The taxable income used by income-tested clawbacks is typically about 25% of self-made dividends, but 138% of ordinary dividends. Ordinary dividends can be a disaster for seniors!

Are you taking principal, while ordinary dividends are income?

Rainfall and snowfall are both precipitation. Similarly, capital gains and dividends are both part of the total return on your investment.

With equity investments, there is no such thing as “principal”. The valid factor is “net invested” – cash invested less cash withdrawn. Whether you receive self-made dividends or ordinary dividends, you are withdrawing cash from your investment.

This requires some background knowledge on stocks. Companies can do 4 things with their profits – reinvest in the business, buy other companies, buy back their own shares, or pay dividends. If companies did not pay dividends, they could grow their company faster by reinvesting. Many companies are doing share buy-backs instead of paying dividends today. This is more tax-efficient than paying a dividend and means investors own a larger portion of the company. All 4 uses of cash contribute to total return.

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

Ordinary dividends have no magic.

Summary

In short, self-made dividends are better than ordinary dividends in essentially every way. Dividends have 2 big risks – over-valuation and lack of diversification. Self-made dividends avoid both risks and have a list of major advantages, especially lower tax, better investment options and complete flexibility.

Self-made dividends are a perfect fit for a retirement plan. They fit your life.

Ed

* In most cases, the “book value” of your investments would be higher than $500,000, because the book value changes every time you buy and sell investments, and because the book value includes reinvested dividends or capital gains distributions. Therefore, the portion of the $40,000 self-made dividend that is taxable would be less than $10,000.

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Ed has a unique understanding of how to be successful financially based on extensive real-life experience, having written nearly 1,000 comprehensive personal financial plans.

The “Planning with Ed” experience is about your life, not just money. Your Financial Plan is the GPS for your life.

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20 Comments

  1. Conrad on November 3, 2016 at 1:31 PM

    Well done Ed. Systematic Withdrawal Plans have always been a great way for retirees to access their money tax efficiently. Unfortunately this “simple solution” oftentimes gets forgotten. Using a T-SWP on a mutual fund can further enhance the tax savings on Self Made dividends by providing tax free income for a period of time by deferring taxes out 10-15 years.



  2. Ed Rempel on November 6, 2016 at 5:07 PM

    Thanks, Conrad.

    It’s good to hear from you!

    I just found this from Vanguard thinks self-made dividends are a huge advantage over ordinary dividends.

    In their article about the value of an advisor, Vanguard says that getting clients to think total return instead of income for funding their retirement is one of the biggest values an advisor can provide for clients.

    Here is the quote from Vanguard

    “Benefits of a total-return approach to investing:
    In pursuing the preceding income strategies, some may
    feel they will be rewarded with a more certain return and
    therefore less risk. But in reality, this is increasing the
    portfolio’s risk as it becomes too concentrated in certain
    sectors, with less tax-efficiency and with a higher chance
    of retirees falling short of their long-term financial goals.

    As a result, Vanguard believes in a total-return approach,
    which considers both components of total return: income
    plus capital appreciation. The total-return approach has the
    following potential advantages over an income-only method:

    • Less risk. A total-return approach allows better
    diversification, instead of concentrating on certain
    securities, market segments, or industry sectors
    to increase yield.

    • Better tax-efficiency. A total-return approach allows
    more tax-efficient asset locations (for clients who have
    both taxable and tax-advantaged accounts). An income
    approach focuses on access to income, resulting in the
    need to keep tax-inefficient assets in taxable accounts.

    • Potentially longer lifespan for the portfolio,
    stemming from the previous factors.
    Certainly, to employ a tax-efficient, total-return strategy
    in which the investor requires specific cash flows to
    meet his or her spending needs involves substantial
    analysis, experience, and transactions.

    To do this well is not easy, and this alone could also represent
    the entire value proposition of an advisory relationship.”

    Ed



  3. Commodity Tips on November 29, 2016 at 9:22 AM

    The given article is a great source of information and figures about the particular topic. You nicely described this. I am very impressed by your effort.



  4. Can we retire now? Retirement rules of thumb on January 23, 2018 at 2:21 AM

    […] or dividends, if they would reduce your long-term total return. Systematic withdrawals (or “self-made dividends“) give you control and are the lowest taxed investment […]



  5. Russ McGillivray on January 23, 2018 at 4:19 PM

    Ed,
    Attractive concept, but I think you should say at the outset that this only applies to people whose retirement funds are in non-registered accounts.



  6. Ed Rempel on January 23, 2018 at 6:48 PM

    Hi Russ,

    Good point! I thought I had said it was for non-registerd investments, but I didn’t. I added it now, right at the beginning.

    Thanks, Russ.

    Ed



  7. EL on April 22, 2018 at 9:26 PM

    Hi Ed,

    Where can we set up the self made dividends account? Do I have to have 500k cash to have it set up?

    El



  8. […] or dividends, if they would reduce your long-term total return. Systematic withdrawals (or “self-made dividends“) give you control and are the lowest taxed investment […]



  9. Ed Rempel on May 11, 2018 at 10:45 PM

    Hi EL,

    Self-made dividends just mean you sell a bit of your investments each month to give you cash flow. It means you can invest for total returns, instead of focusing on income, such as dividends.

    You can automate this with no fee if you invest with a portfolio manager or in a fund.

    Ed



  10. HC on August 17, 2018 at 5:17 PM

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

    What does 5-6 refer to?



  11. Ed Rempel on August 28, 2018 at 11:00 PM

    Hi HC,

    Ordinary dividends result in a 69% clawback tax for seniors that get the GIS. GIS is clawed back by 50% of taxable income. The way ordinary dividends are taxed, the dividend is grossed-up. For example, a $1,000 dividend becomes $1,380 taxable income. The GIS clawback tax is 50% of this $1,380, or 69% of the $1,000 dividend.

    The self-made dividends will have a far lower clawback tax of only 0-16%. Capital gains only add 50% of the gain to your taxable income. If you sell $1,000 of an investment, a signficant portion is your cost. If your investment had doubled up until that point, then only half of the $1,000 is a capital gain and only have of that gain is taxable. Then the clawback is on 50% of that (3 halfs), which means it would be only 12.5%.

    In short, the ordinary diviend has a clawback tax of 69% vs. 12.5% for the self-made dividends. This is 5-6 times higher. You can see this in the chart in the article.

    Ed



  12. Damproofer in tewkesbury on December 21, 2018 at 1:14 AM

    WOW. Just whqt I was looking for.



  13. Victor on August 28, 2019 at 2:47 PM

    Great article Ed. But you didnt consider dividend tax credits!



  14. Ed Rempel on September 15, 2019 at 9:27 PM

    Hi Victor,

    I did consider the tax credits. Dividends usually end up with some tax to pay, even after the tax credit (except for low income people), while deferred capital gains have zero tax until many years in the future.

    Capital gains and dividends are both taxed at preferred rates. The tax rates are similar, except that low income people pay less with dividends and higher income people pay less with capital gains.

    However, dividend tax is payable every year. Capital gains tax can mostly be deferred for years or decades.

    Would you rather pay tax on a dividend this year or tax on the same amount taxed as a capital gain 20 years from now?

    Ed



  15. […] and investments each year, investing tax-efficiently for deferred capital gains or dividends, using tax-efficient withdrawal strategies such as SWPs, using “T-SWPS” to defer capital gains, deferring CPP and/or OAS to age 70, starting CPP early […]



  16. Sonia U on March 18, 2021 at 12:31 AM

    Hi Ed,

    It’s clear that the Deferred Capital Gains is the most optimal for the long-term and capital gains benefit favorably with tax treatment and GIS and OAS claw backs compared to Canadian Dividends.

    For an active investor looking to build a core portfolio of long-term stock holds (focus on never selling, forever bull) by investing in a mixture of value and high growth / cash flow and some future speculative growth companies assuming manageable diversification (10-30 stocks depending on convictions) and buying lows / DCA , my biggest concerns for the long-term into retirement age, is around black swans and cyclical market recession risk, and inflation impacts (especially if you are unlucky and you’re retiring into recession period):

    What are your thoughts around actively managing a long-term portfolio to minimize / avoid this if the idea is to not sell for the long term?

    The market ebbs and flows and we have sell offs from overbought or hedge funds HFT induced sell offs and market manipulation.

    My understanding so far is that there are benefits in actively employing one or more of the following various forms of hedges to ‘smooth out the equity returns over time’
    – Sell Covered Calls
    – Sell Covered Calls + Puts on the specific Stocks
    – Financing Index Puts (SPX, QQQ) with Premium Selling
    – VIX Hedges

    All have some level of keeping tabs on the market overbought/sold and a level of timing. When the hedges are realized for a profit, they become capital gains for that year.

    Additionally, buying after a sell off to dollar cost average to keep a low cost basis could be beneficial.

    What is your overall take on this?

    Thank you
    George



  17. Ed Rempel on March 22, 2021 at 8:29 PM

    Hi George (or Sonia),

    We see investing completely differently than the investment industry. We think long-term – because we are focused on our clients’ life goals.

    The clearest way to see this is in our definition of risk. The investment industry defines risk a market fluctuation or the risk of a decline. This is short-term or medium-term risk. We think of it as turbulence – but not real risk.

    We define risk as getting a long-term return too low to achieve your life goals. For example, if your retirement plan is based on a long-term return of 8%/year, then we define risk as getting a 25-year return below 8%/year.

    For us, adding fixed income to your portfolio increases the risk, since it makes it more likely your long-term return will be below 8%/year.

    We don’t worry about the issues you mentioned. Black swans, market cycles, inflation and recessions come and go – and then the market continues it’s long-term uptrend.

    Here is my insight: People that worry about those things have lower returns than people that don’t.

    This is because the market is going up the vast majority of the time and there is no reliable way to predict the next downturn.

    The #1 secret to investment success is (here it is…) getting at least 10)% of the growth in the up markets.

    We just had an 11-year bull market – essentially straight up from 2009-20. In that time, nearly every day there was an article from someone about this being a long bull market and we need to prepare for the next bear market. How many of these writers made 100% or the growth of the 11-year bull market?

    The investment methods you mentioned may all reduce turbulence, but likely will also reduce your long-term return.

    My overall take is to ignore turbulence and focus on things that can reliably maximize your long-term return.

    Ed



  18. Marina on August 15, 2021 at 7:29 PM

    Hi Ed,
    Thank you for sharing your knowledge so generously. I came across your blog through my work Slack channel where someone mentioned it. I have been binge-reading since then! I actually had a question about The Smith Manoeuvre before I saw a link to the self-made dividends article you gave someone in the comment section. Now I am a bit confused with what strategy would work best in our situation. I am not sure you are still monitoring the blog, but here goes.

    I am 56 and my hubby is 64. He will most likely work for another 2-3 years since he likes his job.

    Me
    Salary $115,000
    RRSP $350,000
    TFSA $50,000

    Him
    Salary $90,000
    RRSP $130,000
    No TFSA

    Our combines cash position is $150,000

    We have two properties both at $600,000 at today’s market value. One in ON is owed outright; another in BC carries a mortgage of $360,000. Both have rental income. We just sold our primary property and temporarily moved in with our daughter. Next year we are planning to move to one of the properties.

    Now the question: what should be the right strategy for us to start a cash flow in the next 5-10 years? Should we sell the paid-off property and invest in the non-reg account? I suspect 5-10 years won’t be enough for the growth of capital. Should we implement the smith manoeuvre on the other property? Sorry, I know that I am relatively new to this and it shows.

    Thanks in advance for looking into my question!

    Marina



  19. Ed Rempel on September 14, 2021 at 10:59 PM

    Hi Marina,

    I respond to all questions on my blog. I’ve been a bit slow lately, because we have been working through a waiting list of new clients looking for a Financial Plan.

    For you, the first step is that you need a Financial Plan. You want to retire in 5-10 years. What is the best plan for you? How much do you need per year for the retirement lifestyle you want? Then we can work out the best way to get there. You are right that 5-10 years is not very long, so you probably will need to make some bold moves.

    Your Financial Plan may require some compromise, so you proably need an Interactive Financial Plan (https://edrempel.com/how-an-interactive-financial-plan-is-the-only-way-to-answer-your-life-questions/ ) to work through various life options and financial strategies for you.

    I can’t give you specific advice without knowing much more abour you, but here are a couple insights that might help you:

    1. You are in 40% an 30% marginal tax brackets and you will probably retire in the 20% marginal tax bracket. Therefore, there is a significant benefit for you to maximize your RRSPs before you retire.
    2. Your money is mostly in your 2 properties, which won’t provide much retirement income for you. You still have quite a few decades in front of you. Stock market returns are many times higher than real estate over the long term. For example, the TSX60 has had 6 times the growth of Toronto real estate the last 40 years. Your retirement will be much more comfortable if you have a much higher amount in equities. Selling the paid off property to invest in equities should help your retirement a lot.
    3. Real estate can have a decent rate of return if it is highly leveraged. My general rule of thumb is that when the mortgage is down to half the value of an investment property, it’s usually best to sell it to invest in equities. You can make a property worth keeping by doing the Smith Manoeuvre. This would apply to both your properties. This can give you $600,000 to invest. You can invest it either in the Smith Manoeuvre or in RRSPs, depending on your situation. Borrowing for RRSPs is not tax-deductible, but you could get large tax refunds if you have significant RRSP rooms.
    4. A large Smith Manoeuvre strategy can set you up for a very tax-efficient retirement using Self-made Dividends.

    I hope that is helpful for you, Marina.

    Ed



  20. Gurjit Sidhu on September 26, 2021 at 6:28 PM

    Hi Ed, long time reader and fan. Appreciate all your sharing of information over the years and now.

    I saw your presentation on the Canadian Financial Summit and it made a lot of sense to me. However I did have one question.

    You mentioned that Self-Made Dividends can consist of “Any stock”. However if a good portion of your Self-Made Dividends Portfolio were to be Dividend Paying stocks then wouldn’t the dividends they do pay also add to your Taxable Income? And thus skew some of the tax amounts you mentioned?

    Let me know if I’m missing something?



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