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Tax Free Passive Income

Passive Income Builds Over Time

This article is written with politics aside.  It is a simple informational article based on recent legislation being written into law.

As of Friday, December 17, Americans now have the opportunity to continue earning tax-free passive incomePresident Barack Obama signed into law an extension of the Bush Era Tax Cuts which allows citizens to enjoy tax-free (or lower taxes) on Qualified Dividend Income.

If you want to know more about what is qualified, then be sure to read the article on Wikipedia about qualified dividends.  If you fall in the 10% and 15% rates, then your dividends will be tax-free, if you normally pay at a higher rate then you will enjoy the lower 15% tax rate.

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For a visual summary, I’m including a modified version of the tax rate table from the Wikipedia article linked above:

Dividend Taxation in the United States: 2008
2008–2010 2011
Ordinary Income Tax Rate Ordinary Dividend
Tax Rate
Qualified Dividend
Tax Rate
Ordinary Income Tax Rate Ordinary Dividend
Tax Rate
Qualified Dividend
Tax Rate
10% 10% 0% 15% 15% 0%
15% 15% 0% 28% 28% 0%
25% 25% 15% 31% 31% 15%
28% 28% 15% 36% 36% 15%
33% 33% 15% 39.6% 39.6% 15%
35% 35% 15%

Many have heard people like Robert Kiyosaki, and Dave Ramsey tout passive income ideas from the tops of mountains. Income is always great, but tax-free income is even better for you. Few would pass up the opportunity of not having to pay taxes ever again.

I’m sure there are a few out there who would say “give me the taxes, it’s my civic duty” but I’d say they’d be the exception more than the rule. If you haven’t been building a dividend portfolio, then now is definitely a great time to get the ball rolling.

Market Stability

Before jumping head first into dividend paying stocks, it is definitely good to examine market stability.  I will not make any wild claims about market stability, but I do believe that if you can get into some of the more steadfast, and “boring” blue chips, then you can enjoy the tax-free dividends while enjoying some safety (again, no safety is guaranteed).

Things to look for in dividend paying stocks:

  • Key ratios like P/E, DPR, PEG
  • Consecutive years of dividend increases.
  • Earnings % increases should be larger than Dividends % increases.
  • Big, stable, diversified, and well-known companies are a huge plus!
  • Decent starting dividend yield (but keep yield on cost in mind)

Things To Keep In Mind

This tax break is only meant to sustain us through the end of 2010 and throughout 2011.  It is possible that regular taxes may come back in 2012 and this should be apart of your pricing model.  While there has been strong bi-partisan support for these tax breaks (especially if you are in the lower brackets) the reality of generous tax breaks may come home to roost, and they could be wiped out completely!

I find it terribly unlikely that they would wipe out all of the tax breaks completely, but desperate times will call for desperate measures and everything will be on the table for cutting.  If building a decent dividend portfolio will take you years, and tax hikes will destroy you, then it would not be advisable to gamble on this plan.

Income Opportunities Are Knocking

Not often are we presented with such an excellent opportunity to save, invest, and generate income at nearly 100% efficiency.  It is important to look at all possibilities and consider all options.  Bank CDs, money market interest, and many other forms of income will not have this tax advantage, so it will be important to consider these in your risk/reward calculations if you are going to be comparing apples-to-apples.

To everyone who has already been taking advantage of these tax-breaks, good for you.  You’ve been forward thinking and you are doing a great job of maximizing your dividend return.

Image: worradmu / FreeDigitalPhotos.net

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