I filed my taxes on Wednesday. Perhaps, influenced by blogging, this was the first year I truly looked at my tax return closely above and beyond looking at the refund or payment line on the last page of the return. Reading the last page of the tax return is akin to buying a book and reading the last page and ignoring the rest- you know how it ends but you miss all the details.  And, as they say, the devil is in the details.

If you flip to your tax return, there should be a page devoted to “Total Income” which, as the name implies, is the aggregate of all the income you have made in any tax year. Income for tax purposes is typically divided into the following sections (I am going to skip the government benefits like Old Age pension and child care benefits):

• employment income
• taxable dividends
• interest and other investment income
• interest from income trusts (known as “other income”)
• business income
• professional income
• commission income

The lines that should really concern all of us are the passive income items: taxable dividends, interest and other investment income and interest from income trusts (collectively, “Passive Income”). You want these to grow faster than employment/business/professional/commission income (collectively, “Working Income”) for two reasons.

Passive Income is generally taxed more favorable than Working Income. For example, the effective tax rate for dividends in Canada is as low as 3% to 30% depending on you income tax bracket and jurisdiction. The dividend tax rate in the United States is 15% (until 2011). This is generally lower than the top tax rates for Working Income (which can be upwards of 46% of income). In other words, the government, through its tax policy, is encouraging you to invest in passive income instruments.

The other reason is simple- you are putting a smaller amount of effort to yield Passive Income than Working Income to gain a greater reward (and greater take-home due to lower tax rates). The typical reaction to making more money is to increase Working Income by asking for a raise, working more hours (if that’s possible), selling more in the your business etc. This requires a lot of effort and, given that our tax systems is progressive in nature (income tax rates rise as your income does), you are, in many respects, being discouraged by the government to work harder since the harder you work, the more tax is being taken off.  Whereas, Passive Income, such as dividends payments, require less effort to generate and is taxed more favorably.

I am going to use my “taxable amount of dividend” line in my tax return to track my progress towards achieving multiple streams of passive income.  Instead of completing your taxes, filing them and then putting them in a drawer for the rest of the year, consider using it as a tracking tool if you are interested in making passive income.

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I am privileged to be a part of the Carnival of Personal Finance-Chasing Dreams edition hosted by the Happy Rock. Please visit the Happy Rock blog and all the carnival entries.

Have a great weekend.