Over the course of this week, I am going to discuss taxes on investments, and using tax deferred vehicles. This is the first article of a series of three articles on the subject that will appear this week. I am not a tax adviser, and the facts I have presented as well as conclusions are derived from my personal understanding of the tax code. Any examples are made up, and are not a recommendation to do anything. As everything else you read on this site, use it for entertainment or educational purposes.
One of my favorite sites on dividend investing is written by Jason Fieber from Dividend Mantra. This is an average person, with an average income, that manages to save a very high portion of his income and then invest it in dividend paying stocks. What makes him unique, is that he shares all of the numbers behind his income, expenses, savings and investments. One of the reasons why I like his site is because I personally share a lot of similarities with him – I save a very high amount of my income, I am close to his age group, and I keep putting my hard earned money in dividend growth stocks. Just like him, I plan on retiring early.
Over the past 2 months, Jason wrote an article on why he doesn’t invest in tax-advantaged accounts. His point was that because he invests in dividend paying stocks, and because he plans on retiring at the age of 40, tax-advantaged accounts such as 401 (k) and Roth IRA’s would not work for him. Dividend paying stocks provide a source of income, which is extremely tax efficient. This is because for qualified dividend income under $36,250 for single taxpayers and under $72,500 for married filing jointly taxpayers, the effective tax rates would be zero.
I used to think exactly like him until earlier this year. I rarely mentioned this on this site before, but I do plan to be able to retire at a fairly young age. In order to do so, I have been avoiding debt like the plague, and I have lived below my means, while trying to increase my income as much as possible in the process. As a result, since 2008, I have been accumulating cash and putting it to work into dividend paying stocks in taxable accounts. So far in 2013, I expect to be able to cover 50 - 60% of expenses with dividend paying stocks.
When I paid my taxes for 2012 however, I realized that the total amount I was paying to the Federal and State governments was the highest expense in my household budget. The expense easily exceeded my housing expenses, and my transportation expenses. As a result, I realized that while I was working extremely hard to minimize expenses and increase income, I had some serious leakage in terms of taxes. This is something that websites focusing on early retirement never really mention. I find it absolutely amazing that they never go there. I find it weird, because some people are willing to take sacrifices in making their own toothpaste, wait for buses in the rain, or forego paying for health insurance, or work over 50 hours/week at a job they detest, while having the largest expense in the form of income taxes to Federal, State and City governments.
In my case, this leakage meant that $30 of every $100 I made over a certain threshold went to taxes. This made it much more difficult to accumulate assets. In retrospect, since my income has been increasing over the past six years, I did not pay attention to this phenomenon. Now that I am planning on trying to be able to become financially independent in five years, I am trying to find innovative ways to increase income, keep as much as I can, since you can only cut costs so far. If I could somehow minimize the tax bite out of my earnings, I could be able to amass much more in assets, which could translate into higher levels of dividend income over time for me. After all, if I earned $70 after paying $30 in taxes, and put it into a dividend stock that pays a 3% yield, I would only earn $2.10 in annual dividend income. However, if I somehow legally avoided paying $30 in taxes, I would be left with $100. This could earn $3 in annual dividend income. This means that by trying to outsmart the tax person, I can end up with a 42% increase in income. If I were planning on retiring in 10 years, this tax efficient method could result in me shaving off 3 years from that journey. This could potentially mean I could retire in 7 years, rather than 10.
The solution was really easy. It is essentially something that any personal finance or investing blog has discussed at least once in their lifetime – use the tax-advantaged account to the maximum. In general, if you are a single taxpayer that has taxable income exceeding $36,250/year, you are paying a 25% marginal tax rate. If your taxable income is $53,750/year, you are essentially paying a 25% tax rate on the last $17,500 of income you make. However, if you put this money in a 401 (k) plan, you would have $17,500 to your name and you would be able to save $4,375 in annual tax expenditures. Furthermore, any gains in the investments in your 401 (k) would not be taxable, until you become 70.5 years old or until you start withdrawing these amounts.
If you spend $36,250/year, you would only be able to save $13,125 in taxable account, if your taxable income is $53,750 annually. I am ignoring FICA taxes for the purposes of calculation simplicity and because you have to pay them whether you allocate the money to a taxable or tax-deferred account. However, if you put $17,500 in a 401 (k), you would essentially end up with $17,500 to your name. If the assets you purchased yield 3%, you would essentially be earning much more in the second scenario.
Check my next article on taxes.
Full Disclosure: None
- My dividend crossover point
- When can you retire on dividends?
- Dividend Investing Goals for 2013
- Will higher taxes bring dividend stocks down?
- Why I am not worried about the Fiscal Cliff and Dividend Tax Hikes?
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