Showing posts with label taxes. Show all posts
Showing posts with label taxes. Show all posts

Wednesday, March 23, 2016

How to Earn $95,000 in Qualified Dividend Income, and pay no taxes

There are two certainties in life – death and taxes. Every April, we have to file a tax return with the Federal government and pay our taxes due. Whenever I do my tax return, I always come up with the same conclusion: The US tax code is set up in a way, that it encourages investing, and discourages working for money.

For example, qualified dividends are taxed at an effective rate of zero percent for those individuals who are in the 15% tax bracket. The 2015 tax brackets for a couple that is married and filling jointly is posted below (Source:

Taxable Income
Tax Rate
$0 to $18,450
$18,451 to $74,900
$1,845.00 plus 15% of the amount over $18,450
$74,901 to $151,200
$10,312.50 plus 25% of the amount over $74,900
$151,201 to $230,450
$29,387.50 plus 28% of the amount over $151,200
$230,451 to $411,500
$51,577.50 plus 33% of the amount over $230,450
$411,501 to $464,850
$111,324.00 plus 35% of the amount over $411,500
$464,851 or more
$129,996.50 plus 39.6% of the amount over $464,850

This is the 2015 tax bracket for a single individual (Source:

Monday, January 11, 2016

Living off dividends in 2016 – My New Goal

I posted my goals for 2016 a few weeks ago. After some changes that I became aware of subsequent to posting the article, I have some changes.  I have had some change in plans about my goals for 2016. I have decided to essentially live off dividends in 2016. I will be spending my dividend income that comes from my taxable accounts. My annual expenses are close to $18,000 – 24,000/year. My taxable dividends are approximately $10,000 - $11,000/year ( out of $14,000 - $15,000 in total dividend income). The shortfall could be covered by any side income activities I engage in.

I have decided to try and save my entire paycheck in 2016, after taxes of course. I will manage to do that by taking the maximum contributions to my 401 (k) and Health Savings Account (H S A) plans. After speaking with several reps at my 401 (k) administrator, I learned that I can make after-tax contributions, which can be converted to Roth. I already plan to max-out my 401 (k) with pre-tax money, which provides me with an instant tax break. I also receive an even larger tax break in my investment through my Health Savings Account. Any after-tax money I manage to put away will be converted to Roth on a few occasions throughout the year. This means that under current legislation, any earnings derived from that money will never be taxable. I would not be opposed if a larger portion of my net worth is held through tax-deferred assets, and therefore any dividends and capital gains would be deferred.

Monday, November 2, 2015

How early retirees can withdraw money from tax-deferred accounts such as 401 (k), IRA & HSA

One of the biggest mistakes I ever made was not maxing out my 401 (k), IRA and HSA accounts between 2007 and 2012. As a result, I ended up paying tens of thousands of dollars in income taxes and taxes on capital gains and dividends. Those are tens of thousands of dollars in taxes that could have built up my networth and passive dividend income. Instead I ended up handing those over to the IRS and my state. The opportunity cost of these money is in the hundreds of thousands if not the millions over the next 30 - 40 - 50 years.

The reason why I never maxed those out is because I didn’t know a lot about them. I also prided myself with my success that I was paying a lot in taxes. When I was doing my 2012 tax return however, I was sick that my total tax liability exceeded the amount I paid on housing and food. In fact, the amount I paid in taxes was equivalent to what I can live on in retirement. I saw that a fellow blogger from the site Budgets Are Sexy had written about maxing out his SEP IRA and Roth IRA’s, thus saving tens of thousands of dollars in taxes just for one year. So I opened a SEP IRA and maxed it out, saving 30 cents in taxes from every dollar I contributed to. Here was I researching companies, competitive advantages, earnings and valuations, yet I had overlooked the simple power of tax-deferral and tax-deferred compounding of capital. As I kept researching, I I found the sites of Mad Fientist and Go Curry Cracker, which opened my eyes on the benefits of tax deferred accounts. These investors had managed to retire early by taking advantage of the tax code, and then were paying zero dollars in taxes during their early retirement. Another one I thoroughly enjoy is Justin from Root of Good, who retired at the tender age of 33 and paid pretty much zero in taxes.

My biggest misconception was the fact that I thought that the money is locked until the age of 59 and a half years, and that I cannot touch the money. This was wrong. I also see this misconception has deep roots in many dividend investors I have talked to. These investors mistakenly believe that you cannot withdraw money from retirement accounts when you are aiming for early retirement in your 30s or 40s or 50s. As a result of this misconception, these dividend investors will end up hundreds of thousands of dollars poorer over their lifetimes. This is the reason why I am writing this article. Ever since I had my awakening moment in 2013, I have tried to educate investors. I have been unsuccessful for some, but I will continue fighting.

Monday, August 17, 2015

Tax Loss Harvesting for Dividend Investors

As an investor my goal is to attain financial independence using my dividend growth strategy. As a dividend investor, my goal is to generate enough dividend income to pay for my expenses in retirement.

In order to achieve this goal, I have spent several years selecting quality dividend paying stocks. However, as I gain more knowledge, I also try to pick new tricks that would help me on my journey.

One of those tricks is tax-loss harvesting. Tax loss harvesting is selling securities at a loss in order to offset a capital gains tax liability. Tax loss harvesting is typically used to limit the recognition of short-term capital gains, which are normally taxed at higher federal income tax rates than long-term capital gains.

The benefit of tax-loss harvesting is that I will reduce my taxable income, which will reduce taxes I pay and results in more money available for me to allocate.

A taxpayer can use that loss to offset against other short-term or long-term capital gains. If there are no capital gains however for the year, then the taxpayer can reduce their income by $3,000 at most of a given year. If their capital loss exceeds $3,000, they can use it on future gains they incurred. If that taxpayer never earns another dime in capital gains, they can go on to reduce their income by $3,000/year, until their capital loss is exhausted. Depending on your marginal tax rates, triggering this $3,000 loss could result in a substantial tax benefit. I am in the 25% tax bracket, which means that $1,000 in capital losses translates into a reduction of my tax liability by $250. This of course assumes I earned no capital gains. However this is not a problem for me, since I am quick to book my losses, but I let my gains compound for years.

Wednesday, April 1, 2015

Taxable versus Tax-Deferred Accounts for Dividend Investing

Dividend investing is a great strategy for accumulating income producing securities, which pay their owners cash on a regular basis. These cash distributions are viewed as taxable incomes in the eyes of the Internal Revenue Service (IRS). Depending on the taxpayers adjusted gross income, they could end up paying as much as 20% on the dividends they received. Compared to the top marginal rates on ordinary income such as salaries or bond interest however, dividend income has much lower tax rates. In retirement, qualified dividend income will not be subject to federal taxes for married couples earning $95,000/year (assuming no other sources of income). Unfortunately, it would take the average dividend investor years of accumulating assets, before they reach their dividend crossover point. This will result in them paying taxes throughout their accumulation phase. Many investors have the choice to shelter some or most of their investments in tax-sheltered accounts which could either postpone or eliminate the need to pay taxes on their investment incomes. By reducing or eliminating tax waste in the accumulation phase, dividend investors could reach the dividend crossover point much sooner than by doing it with taxable accounts alone.

There are several tax deferred account options for US investors who are still earning a paycheck. These include regular and Roth IRA’s in addition to 401 (k) plans. Each of these accounts has its pros and cons.

Traditional IRA’s provide investors with a tax benefit today, and allow them to compound their gains for years to come but have to take required minimum distributions at the age of 70 ½ years. Distributions are taxed as ordinary income. However there are strict eligibility rules that do not allow high income households to get the deductibility of contributions. Other negatives include the low contribution limit of just $5,500/year. There is a catch-up contribution limit increase of $1,000 for persons who are above the age of 50. The largest negative includes a 10% early distributions penalty that the IRA imposes if someone withdraws funds prior to the age of 59 ½ years. However, you can pretty much invest in almost anything with your IRA.

Roth IRA’s do not provide any tax benefit to investors today, but allow for tax free compounding of capital and tax free distributions from the account at the age of 59 ½ years. Direct contributions can be withdrawn tax-free at any time, although investors need to wait until they are 59 ½ years old, before they can withdraw gains from the account without a penalty. Investors cannot put more than $5,500/year in a Roth IRA, and there are strict income eligibility requirements to open an account as well. There is a catch-up contribution limit increase of $1,000 for persons who are above the age of 50. Another advantage of a Roth IRA is that there are no required minimum distributions requirements. With my Roth IRA’s, I can pretty much purchase any US Dividend Growth Stock I choose, and I like this flexibility. Tax payers are taking a gamble with Roth IRA’s however, as cash strapped Congress could decide to tax distributions in the future. Of course, it is also likely that tax rates on qualified dividend income will increase before Congress doing anything about limiting or taxing Roth IRA's for middle-class consumers.

The 401 (k) plan is the company sponsored defined contribution plan, that millions of Americans are eligible for. The annual contribution limit is $18,000/year for those under the age of 50. If you are over the age of 50, you can contribute up to $24,000/year to your 401 (k). The majority of 401 (k) plans allow participants to put pre-tax contributions today, and enjoy tax-free compounding of capital. They do have required minimum distributions starting at the age of 70 1/2 years old. This is when you will have to pay ordinary income taxes on any money you withdraw from the 401 (k). An increasing number of employers are now also offering Roth 401 (k) contributions, with the same limits as the traditional 401 (k). The nice thing is that contributions are after-tax, the money compounds tax-free, and there are no taxes to pay on investment earnings. The drawback of most 401 (k) plans for many investors is the limitation on the types of investments to choose. A good 401 (k) plan will offer low cost mutual funds to investors. A really good 401 (k) plan will also offer a Brokerage Link window, that would allow investors to pick their own investments. A really bad 401 (k) plan will include high-fee mutual funds with sales loads. If the fund you are purchasing charges an annual management fee of 1%/year, chances are this is part of the offering of a bad 401 (k) plan.

One disadvantage of both accounts (IRA and 401 (k)) is that you cannot deduct investment losses, or offset them against investment gains. In addition, foreign dividends are subject to witholding taxes at the point of origin despite the fact that they are in a tax-sheltered account. Unlike taxable accounts, investors cannot get a tax credit for these foreign tax withholdings. Dividends in tax-sheltered accounts of US investors which are derived from Canadian or UK companies are not subject to tax withholdings.

Despite popular beliefs however, Master Limited Partnerships can be held in tax deferred accounts, as the UBTI which scares investors off is mostly a non-event ( and has been in my few years as an MLP investor, although things might change). In the years that I have owned ONEOK Partners (OKS) and Enterprise Product Partners (EPD), I have never had positive UBTI.

In addition, investors need to choose whether to open a Roth or a Traditional IRA with their $5,500 in a given year, but cannot open both. Investors can still have an IRA and a 401(k) plan however. Given the lack of investment options in 401 (k) plans, they are of limited value to the self-directed dividend growth investor. 401 (k) plans are helpful as a tool to minimize taxes and get the company match, and buy a few index funds, which is why they work for mostly passive investors. The nice thing about 401(k) plans that I utilized in 2013 is that if you quit your job, you can rollover the money into an IRA. After that, you can pretty much invest in anything you want, including creating your own dividend stock portfolio.

In my investing portfolio, I keep most of my holdings in taxable accounts.The taxable accounts give me a lot of flexibility in my investments, and I can add or withdraw as much as I want at a moment’s notice. I do pay taxes on my investment income, but I also get to do tax loss harvesting on my investments.

I expect that by the end of 2015, I would have approximately 10 - 15% in tax-deferred accounts such as 401 (k), IRA, Roth IRA, SEP IRA and Health Savings Accounts (HSA). This is mostly because I used to believe that there are too many restrictions on withdrawing principle and accumulated gains from these tax-advantaged accounts. As a result, I used to contribute only the bare minimum to my 401 (k) in order to get the company match.  As I researched further, I realized that it is possible to withdraw money out of an IRA before the age of 59 and a half penalty free. With Roth IRA's, contributions can be withdrawn penalty-free at almost any time. With 401 (k) plans, investors can start withdrawals penalty free if they have separated from service, and they are 55 years of age or older. Or, just like with IRA's, investors can use Substantially Equal Period Payments (SEPP) and withdraw money to live off at any age. The only catch is that if you start withdrawing money using SEPP, you need to continue doing it for the next 5 years or until you turn 59 1/2 years - whichever is longer.

The part I don't like about taxable accounts is that I was paying too much in taxes on salary and investment income. Taxes are the largest expense item on my personal income statement. Therefore, I have been maxing out all tax-deferred investment vehicles like crazy since early 2013 (luckily for some I was able to contribute for 2012 as well). I have saved tens of thousands of dollars in Federal and State taxes in the process. Prior to that epiphany, I had only contributed slightly more than the employer match I received. If I had to do it all over again, I would have been much smarter about the tax-efficiency of my investments. If my accumulation phase lasts for one decade, this means I would have to pay taxes on the money I want to invest in a taxable account, and then pay taxes on distributions I receive for that entire decade. It is little consolation that when I become FI, my dividend income will be tax-free. When you have too much waste in the accumulation phase of investing for retirement/FI, you end up with less money to invest, since you are paying so much in taxes.

My goal in retirement is to essentially live off dividends (qualified dividends) and pay no taxes in retirement. Using 2015 rates, a couple that is married and filing jointly will not pay any federal taxes if they earn less than $95,500 in qualified dividend income. This exercise assumes that the couple has no other source of income.

The couple will have a standard deduction of $12,600, and the personal exemptions will be $8000 ( $4000 per person), for a total of $20,600. In order to avoid paying taxes on qualified dividend income, the couple needs to make sure that they stay in the 15% marginal tax bracket. The highest income per that bracket for 2015 is $74,900. Therefore, adding $74,900 to $20,600 gets us up to $95,500.

My strategy for tax-free income is to live off qualified dividends and not pay any taxes in the process. However, I also expect to convert 401 (k) and IRA balances into Roth slowly. You can recall that I get a 25% - 30% deduction for putting money in 401 (k) and IRA today. My goal is to convert that amount in 401 (k) and IRA slowly into a Roth IRA when I retire, and to pay no taxes in the process.

How is that possible?

Let’s assume that a married couple files taxes jointly and has no other income than $74,000 in annual qualified dividends. This means they will pay no taxes on that qualified dividend income. However, if they rolled over $20,600 from an old 401 (k) into a Roth IRA, they will pay zero taxes on the conversion.

This is possible, because a 401 (k) to Roth IRA conversion creates ordinary taxable income. However, ordinary taxable income that is lower than the sum total of the standard deduction and personal exemptions creates a taxable liability of zero. The sum total of the standard deduction and personal exemptions for a married couple comes out to $20,600 for 2015. And of course, since the sum of the $20,600 IRA conversion and the $74,000 in qualified dividend income is less than $95,500, the total income stream will be tax-free at the Federal level.

Therefore, if the couple has a 401 (k) with $100,000 in it, they can expect to convert it into a Roth IRA within 5 years or so and pay no taxes in the process. This is a pretty sweet deal, because the couple likely received hefty tax breaks in saving the money into a 401 (k) in the first place. However, they converted it into a Roth IRA, which means that any future distributions from this Roth IRA will be tax-free. This is the type of deal where you get your cake and you eat it too, which is very appealing to the Dividend Growth Investor.

And to add another thing for you to think about, it is important to complete these 401 (k) to Roth IRA conversions before you start claiming Social Security benefits. This is because the addition of Social Security Benefits will increase ordinary taxable income, and could lead to paying some tax on the 401 (k)/IRA to Roth IRA conversion. In addition, it is really important that the conversion of a 401 (k)/IRA to Roth IRA occurs prior to the age of 70 and a half years, in order to avoid having to make required minimum distributions (RMD). Those Required Minimum Distributions from a 401 (k) or IRA are subject to ordinary income taxes. If you have already completed the conversion to a Roth IRA prior to the age of 70 and a half, you will not have to make required minimum distributions. This is why tax planning is so important - it can add more money for the investor, speed up the process of asset accumulation, and reduce tax expenses in retirement.

Full Disclosure: None

Relevant Articles:

How to Retire Early With Tax-Advantaged Accounts
My Retirement Strategy for Tax-Free Income
Dividends Provide a Tax-Efficient Form of Income
My Dividend Goals for 2015 and after
How to accumulate your nest egg

Tuesday, February 24, 2015

How to save over $60,000/year in a Roth IRA

Recent changes in tax laws have made it possible for some people in the US to potentially defer over $60,000/year in a Roth IRA. This is perfectly legal, but requires some research upfront in order to see if you qualify, and whether it makes sense to do it. I believe that this article will be relevant for only a portion of you, because this opportunity might not be available for everyone. This new opportunity includes maxing out a Roth 401 (k) for $24,000, maxing out after tax contributions for the remaining $35,000 (assuming no employer match), as well as maxing out a Roth IRA with $6,500. The article will try to explain how some people can save $60,000/year in a Roth IRA per year, and assumes they are over the age of 50, earn more than $60,000/year, and are able and willing to defer that much in a retirement account. Nothing in this article should be considered tax planning advise for you however - please remember to always speak with a Certified Public Accountant before making any tax planning decisions.

As someone in the accumulation phase of my dividend investing journey, I end up paying a lot in taxes. In previous posts, I have discussed the strategies I am implementing in order to shorten my time to financial independence. Qualified dividend income is very tax efficient. It is quite possible to earn $90,000 as a married couple filing jointly, and pay no taxes if you have no other form of income. However, in order to get to that point, you would have to pay steep taxes in the accumulation phase. A married couple whose taxable income exceeds $73,800 in 2014 would have to pay 15% on dividend income received. By paying expensive taxes on dividends today, you are essentially shortchanging your full potential. If you can somehow avoid paying taxes on dividend income and capital gains in the accumulation phase, you can potentially shave a few years of working. I don’t know about you, but it makes sense for me to avoid filing TPS reports for 2 – 3 extra years, if I have the option to not file them. Of course, if you enjoy coming in on Saturdays and Sundays, then chances are you won’t like this article.

Many investors I talk to have used Roth IRA’s to soak up as much in quality dividend paying stocks as possible. The Roth IRA allows them to withdraw contributions at any time, lets money compound tax-free forever, doesn’t have required minimum distribution requirements for the original contributors and its earnings are not taxable if withdrawn after the age of 59 ½ years. The main problem with the Roth IRA is that contributions are limited to $5,500/year for every person under the age of 50 who has employment income. If you are over the age of 50, you can defer $6,500/year. This is not a lot to make a serious dent for you however, especially if you are one of the big savers who dreams of early retirement on your own terms. To add insult to injury, workers who make too much money are not allowed to put money in a Roth IRA. Luckily, there is a backdoor solution, where you can make a non-deductible contribution to a regular IRA, and then rollover the money into a Roth IRA. This involves more paperwork, but achieves the result.

There is another way to contribute up to $18,000/year in a Roth 401 (k) account as an employee. The problem is that not every employer allows it, some 401 (k) plans have terrible investment options, and not many 401 (k) plans offer a brokerage window to select your own stocks. The nice thing however is that even higher earning employees can contribute to the Roth 401 (k). If you are older than 50, you can take advantage of the catch-up contributions which are $6000 extra.

Some 401 (k) plans allow employees to make after-tax contributions to their 401 (k) plan. This is different than after-tax Roth 401 (k) contributions. The contributions I am talking about today are called after-tax contributions. Some 401 (k) plans allow their participants to contribute money after-tax. Up until now, it didn’t make sense to put after-tax contributions to a 401 (k). However recent changes made it potentially profitable.

One thing you might want to know is that the amount you can defer in your 401 (k) is limited to $53,000/year for those under 50 and $59,000/year for those over 50. This includes not only your employee contribution of $18,000/$24,000/year, but also the employer match. Anything left over could be put in a 401 (k) amount as an after-tax amount. If you make $80,000/year, and your employer matched 4% of your pay, that is a neat $3,200. Employer matching contributions are always pre-tax however. Either way, an employee under the age of 50, who earns $80,000/year, gets a 4% match and maxes out their 401 (k) with $18,000, can potentially get $21,200 deferred in their 401 (k). They can then contribute up to $31,800 in an after-tax 401(k). This is calculated as the difference from the limit of $53K, minus the $18K in annual contribution, minus the $3,200 matched by the employer. For someone over the age of 50, they can contribute $37,800 more, due to the $6000 catch-up contribution.

The other hurdle that you want to check is whether the 401 (k) plan allows you to either transfer those after-tax contributions to a Roth IRA account, or if it allows you to do a Roth conversion within the 401 (k) account. If your plan allows you to make after-tax contributions, but does not allow you to convert those immediately into a Roth IRA or Roth 401 (k), then the information in this article might not be worth it for you. This is because if your after-tax contributions are left in a regular 401 (k), any gains are treated like ordinary income upon distribution. Since you don’t want to pay ordinary taxes on investment income, it made no sense to use after-tax contributions before. However, under current legislation, when you quit your job, you can transfer the after-tax contributions to a 401 (k) into a Roth IRA. The gains from those money will be transferred to a regular IRA.

If you want to avoid this, you have to convert the after-tax money to a Roth IRA/Roth 401 (k) right away. That way, all gains from those contributions are Rothified and you will never have to pay income taxes on them under current tax laws.

However, if you are about to retire from your job within 2 - 3 years, it might still make sense to do the after-tax contributions in a 401 (k), since you are less likely to have earned significant returns over that short period of time (unless you are Warren Buffett, in which case thank you for reading my humble site). But everyone's situation is different, which is why the goal of my article is to tell you there is an opportunity to potentially put $60,000/year in a Roth IRA, and for you to start your research, in order to determine if this move is right for your financial situation.

So to summarize, it is possible for someone over the age of 50 to potentially contribute over $60,000/year in a Roth account. To do this, they need to max out their Roth 401 (k) account with $18,000/year. Then they need to max out their after-tax 401 (k) account with the difference between $59,000 contribution limit, minus the $18,000 Roth 401 (k) contribution, and the employer match. Those after-tax funds would then have to be immediately Rothified either by converting them to a Roth inside the 401 (k) account or by taking an in-service distribution from the 401 (k) account on the after-tax dollars into a Roth IRA. In addition, you can also contribute to the regular Roth IRA up to $6,500/year.

Unfortunately, not all company 401 (k) plans offer the option to make after-tax contributions, and from those that do, not all allow employees to transfer those contributions into a Roth IRA or a Roth 401 (k) while they are still employed by the company. However, contacting your HR department with a request to make the option for an In-Plan Roth Conversion available, might do the trick for you. If they allow it, great. If not, there might be other companies available that offer this for highly sought out employees like you.

The other thing to consider with this tax break is the fact that it could be subject to changes. So if you are able to, it might make sense to research this as soon as possible. Otherwise, it might not be even relevant if you read the article some time in 2016.

Full Disclosure: I am unable to perform this feature, since my HR department doesn't allow for In-Roth Conversions on after-tax accounts.

As always, please discuss your tax situation with a CPA, before making any moves.

Relevant Articles:

Dividends Provide a Tax-Efficient Form of Income
My Retirement Strategy for Tax-Free Income
Health Savings Account (HSA) for Dividend Investors
Roth IRA’s for Dividend Investors

Friday, February 13, 2015

Health Savings Account (HSA) for Dividend Investors

I recently signed up for a Health Savings Account (HSA) with my employer. A Health Savings Account is a tax-advantaged medical account which is available to individuals in the US who have enrolled into a high-deductible health plan (HDHP). For 2015, individuals cannot contribute more than $3,350/year, while families cannot put more than $6,650. There is a catch-up contribution of $1,000 for those 55 or older. Individuals who are enrolled in Medicare are not eligible to open an HSA. I signed up for the HSA mainly as another way to defer money for future investment. As most of you know, I am already maxing out other tax-deferred accounts in an effort to cut one of my largest expenses.


An HSA offers a triple tax advantage in most states. The contributions are before tax, which means that the account holder does not pay Federal, State and FICA taxes. If you were in the 25% marginal tax bracket, had a 5% state income tax rate, and you didn’t pay 7.65% for FICA, you will end up saving 37.65% merely by contributing to an HSA account. On $3,350, this comes out to $1,261.27 in tax savings right off the bat. The money can be used for qualified medical expenses at any age, without having to pay any taxes on such withdrawals. However, support documentation should be retained in case of an audit. Withdrawals not for qualified medical expenses are subject to a 20% penalty and income tax. After age of 65, withdrawals are tax-free for any type of distribution from the account.

I was attracted to HSA’s because of the large tax deduction. When I contribute money to a tax-deferred vehicle, I have more money under my control, since I reduce the largest expense in my household budget ( taxes). I have done a similar thing by maxing out 401 (k) and Sep IRA contributions since early 2013. I was also attracted by the fact that money put in an HSA account compounds tax-free. In addition, unlike a Flexible Spending Account (FSA), the money does not have to be used by a certain date. Hence with an HSA the money carries over from one year to the next, and thus stays in the account and could potentially compound over time.


One of the major drawbacks to HSA accounts is the large monthly fees with many providers. When I reviewed different providers, it looks like a minimum account balance that is anywhere between $3,000 - $5,000 has to be maintained in cash, in order to avoid a monthly charge in the range of $2 - $5/month. Many employers tend to cover this amount for their employees, so this is a benefit. However, there are additional fees on each withdrawal, ordering checks to pay for items, opening fees, account closing fees etc. Plus, there are monthly fees if you plan to invest that HSA money into something. This is in addition to the fees for failing to maintain a minimum balance in the account. In addition, most of the investment options are limited to mutual funds, some of which have really high expense ratios that come close to 1%/year.

The one positive thing however is that a person is not stuck with an HSA provider, if their employer offers a crappy HSA provider. One can simply rollover the funds from their original HSA administrator, to the HSA administrator of their choice. This is the thing I plan to do, once I max-out the 2015 contribution. Until then, the money is probably going to stay in cash as it builds up every pay period evenly in 2015.

The other drawback is the low limits on how much one can potentially defer. If limits for individuals are increased to at least match those on IRA or Roth IRA accounts, this would be a good start.

Best Providers

I looked at different providers, and looked at their costs to have an account, and availability of investment options. In my research, I give extra points for companies that are not going to charge me $4- $5/month on a $3,000 - $6,000 balance that takes 1 – 2 years to build up, or at least will not charge me monthly fees after my total balances exceed a reasonable amount of dollars. I am talking about eliminating as much in monthly or annual fees are possible, since some administrators tend to charge you an HSA Bank fee if you have less than $3,000 - $5,000 in a bank, in addition to charging you a monthly brokerage fee. I also wanted to find the broker that would allow me as much flexibility as possible in choosing investments that do not cost me a lot.

My research has identified Saturna Capital as potentially the best options for me. There are no monthly fees, and there is a range of investments such as individual stocks and mutual funds that are available. The commissions are steep at $14.95/trade, and there is an annual inactivity fee of $12.50/$25 for mutual fund/brokerage account. However, if I make at least one transaction per year, this fee is waived. If I end up putting $3,000/year in Saturna Capital and purchase one investment, I will end up paying no more than 0.50% on the total amount invested. Since I plan on building out this HSA account for as many years as possible, I would likely keep maxing out this account, and buying one stock position per year. I will reinvest dividends selectively, and put them to work with the new position. If you like to drip, Saturna Capital charges $1 per reinvestment.

I had never heard of Saturna Capital before, so I did some research. The company is SIPC insured, which is good. The downside is that they seem to require new account-holders to mail in information and forms to open an account, and it cannot be done online. Of course, this is a small price to pay for keeping costs to the minimum, and allowing the maximum amount of compounding free of costs.

The second option I would go with, is Wells Fargo. It looks like HSA accounts with over $5,000 in combines cash and investments do not have a monthly fee assessed. This is good. The not so nice thing is that one is limited to a list of mutual funds only, whose expense ratios are really high. The lowest cost stock mutual fund was an index fund with an annual expense of 0.25%.

The third option could be Fidelity, which charges an annual fee of $48. However, if your household has more than $250,000 in total assets at Fidelity, this fee is waived. Fidelity offers individual stock trades at $7.95/investment, plus it has a decent list of ETF’s or mutual funds with low costs if that’s your route. If you have a 401 (k) with Fidelity that you have contributed to for a while, this could be a good option.

The thing to consider of course is that fees can change if minimum balances are changed as well. Plus, there might be fees assessed if you transfer money from one custodian to the next.

My goal now is to slowly max-out the HSA limit of $3,350 in 2015, and then decide sometime in 2016 on which account to rollover that money to. Although HSA accounts have been around for approximately a decade, the amount of fees charged on them seems very high. Over time, I assume that those fees will decrease. But even if they stayed where they are, Health Savings Accounts make perfect sense for those like me who are looking for another vehicle where they get a tax deduction upfront today, and receiving a tax-advantaged growth of their investments. The real nice part is that after age of 65 I can withdraw the money for whatever reasons I desire, and will not have to pay any taxes. I have decided that even if I have to end up with an index fund in that Health Savings Account, I would be better off than picking individual dividend stocks in a taxable account. Let me walk you through a hypothetical (made-up) calculation.

I calculated that if I choose to invest $1,000 in an HSA that generates a net annual total return of 7%/year, I would end up with $5,807 in 26 years. This return assumes that no taxes are taken and also assumes fees paid are subtracted from returns ( meaning the gross return is slightly higher). However, if I were to earn those $1,000 from my day job but decided not to put them in an HSA, I would be left with $623.50. This is because I would be paying 25% Federal Tax, 5% State Tax and 7.65% FICA. If I managed to earn an after-tax annual total return of 9%/year for 26 years in a row, my account balance will be $5860. The break-even point will be 26 years. Of course I am not comparing apples to apples here, because an after-tax return of 9% in a taxable account usually requires a return above 10% even at today’s low rates on dividends and capital gains.


To summarize, I believe that HSA accounts provide several benefits to investors who want to build retirement savings, and have exhausted common vehicles such as 401 (k) or IRA's. The first advantage of HSA's is triple tax advantage, because of the deduction for Federal, State and FICA taxes. This leaves more money working for the investor. The second advantage is tax-deferred growth of that capital for decades. The third advantage is that this money can be withdrawn at any time, penalty free if it is for qualified medical expenses. It can also be withdrawn penalty and tax-free after the age of 65. The drawbacks include fees, low variety of investment options and the fact that annual contribution limits are low. Of course, for those of us who understand the power of compounding, we know that even a small contribution of $3,000/year over a period of a couple decades could turn into a few nice supplement to the retirement nest egg.

Relevant Articles:

Why I Considered Tax-Advantaged Accounts for My Dividend Investments
Roth IRA’s for Dividend Investors
Six Dividend Paying Stocks I Purchased for my IRA
Twenty Dividend Stocks I Recently Purchased for my 401 (k) Rollover
Nine Quality Dividend Stocks Purchased for the Roth IRA

Tuesday, February 10, 2015

How to buy dividend paying stocks at a 25% discount

Most dividend investors that I know of, spend most of their time screening for companies that fit their criteria, and then research the result, in order to identify quality companies available at good prices. This is the correct way to behave of course, if you want to achieve your dividend retirement goals. I have been following this strategy for the past seven years, and am a living proof that this strategy works. What can be better than putting money to work in great companies available at good prices, getting paid rising dividends every year and then reinvesting those growing distributions into more shares that result in more dividend income each year.

I used to practice my dividend growth strategy for the first four - five years exclusively in a taxable account. My goal is to be able to earn enough in passive dividend income that would cover all of my expenses. After that, I will have the flexibility to do what I want. There as a problem with this sort of thinking however, that I was able to start rectifying in early 2013.

The problem is that I am in the 25% bracket in the eyes of the IRS. This means that for every additional dollar that I earn from employment, I get to pay 25 cents to the IRS. This means that I get less money to buy quality dividend paying stocks. That’s 25% less money to buy quality dividend paying stocks, which means I will be earnings 25% less in dividend income every year.

The other sad part is that in the accumulation phase, I will also pay 15% tax on any dividends I receive. This translates into less money to put in my dividend machine, and less money to compound for me in the long-run. I do not like waste, but that 15% tax sure looks like it. Of course, the amounts start being noticeable after 4 – 5 years of meticulous saving, investing and reinvesting your money, and growing it wisely. It is little consolation that if and when I do decide to never work again for money, my income will be tax-free, because qualified dividends are a very tax efficient way of earning income.

Unfortunately, everyone has to pay taxes. However, it is possible to legally defer taxes. One can put money in a 401 (k) or an IRA, and legally defer taxes for several decades. If I can go through an example, imagine that can afford to save$10,000/year after all taxes and other expenses and that I am in the 25% tax bracket. I can essentially put it in dividend paying stocks yielding 3% and earn $300 in gross dividend income per year or $255 in net after-tax dividend income. However, if I put that money in a 401 (k) or an IRA, I will be able to put $13,333 in dividend paying stocks, and earn $400 in annual dividend income. This is because I am putting pre-tax money to work for me.

In the first example, the portfolio can buy 250 shares of Coca-Cola (KO) at $40/share. In the second example, the investor in the tax-deferred account can buy 333 shares of Coca-Cola at $40/share. Therefore, the first investor who does no tax planning ends up with 25% less shares in Coca-Cola permanently. If the first investor wanted to own the same number of Coca-Cola shares as the second investor, they need the share price to drop to $33.33/share. Hence in essence, the second investor is able to purchase shares at a 25% discount.

In previous articles I have discussed how it is possible to take advantage of tax-deferred vehicles such as 401 (k) plans, IRA’s, and HSA’s in an effort to legally minimize taxes today, and have more assets working for the investor. Later on, it could be much easier to convert those assets into Roth IRA’s, if the investor is mindful of certain income thresholds, without triggering too much in tax liabilities. Of course, tax laws change, and everyone’s tax situation is very different, which is one you should not treat this article as advise to you to act on, but you should talk to a tax adviser that could be able to help in minimizing taxes and maximizing investable assets.

It is very interesting to me that some people spend all of their time and energy trying trying to pick an extra point of dividend yield, but ignore the fact that taxes take a large chunk out of your portfolio. If people spent more time optimizing their taxes, without sacrificing investment quality, they could end up being much better off overall. It is particularly striking that the second investor is essentially ending up with 33% more shares in Coca-Cola than the first investor. Over a period of 3 years, the first investor would have been able to put $30,000 to work for them, while the second investor would have been able to put $40,000 working for them. This means that every 3 years, the second investor is able to save an extra amount that is equivalent to an extra year’s worth of savings.

It is also interesting to observe people who save the money after paying their fair share of taxes, and then accumulate their cash waiting for lower prices. Many of those investors would only put money to work after a 20% correction. I believe that money should be put to work, as soon as they are available to use. In addition, I believe that those who are waiting for a correction, do so only to bolster their egos, rather than try to intelligently allocate capital. There are always opportunities available to invest, which is why I believe those waiting for corrections to have egos, preventing them from fully recognizing the full potential of their capital. If those investors were to utilize tax-deferred vehicles such as IRA’s or 401 (k)’s, they would be able to effectively acquire ownership interests in quality companies at an effective 25% discount.

Of course, this exercise of putting money in tax-deferred accounts is not an excuse to willingly overpay for shares in quality dividend paying companies. Just because you end up with more money using a tax-deferred account, doesn't mean valuation models and due diligence should be thrown out the window. The same entry rules, diversification rules and stock analysis rules apply.

I understand that not everyone has access to a 401 (k) plan that allows them to purchase individual companies. However, given the fact that employees today switch jobs frequently these, it is quite possible that those who put the maximum to their plans today might be able to roll them over into IRA’s when they leave current jobs and invest the money in individual companies. For everyone else, it is possible to take a deduction using regular IRA’s, HSA’s or SEP and SIMPLE IRAs. If you are lucky enough to be self-employed, you can start your own 401 (k) plan using a service such as Fidelity, and possibly defer even more than the $18,000 available for those under the ages of 50. Either way, the important thing is to get you thinking that one doesn't need to save hard, they need to save smart.

I believe it is much easier to save a nest egg that will produce sufficient annual dividend income using a tax-deferred approach, than save that with a taxable brokerage approach. When the investor utilizes tax-deferred accounts, they have more money to work for them, and to compound tax-free for decades. Taking money out of those accounts is not usually an issue, but requires the need to educate yourself how to withdraw money without triggering penalties. Education is a must, since there are different types of accounts, with different rules around them. Learning those rules, and successfully applying them, could result in significant money savings for the time involved. The important thing to remember is that if you pay too much in taxes, that money is lost forever for you and will never compound for you. However, if you get any tax break possible, and invest the money intelligently, one has a better shot of achieving financial independence.

In my case, I plan on getting as much in deductions as possible today ( from 25% - 32%), compound the money tax free for years, and then slowly convert the money into a Roth IRA, without triggering any taxes in the process of conversion.

Full Disclosure: Long KO

Relevant Articles:

My Retirement Strategy for Tax-Free Income
My Dividend Goals for 2015 and after
Dividends Provide a Tax-Efficient Form of Income
Roth IRA’s for Dividend Investors
How to generate income from your nest egg

Wednesday, December 3, 2014

Should taxes guide your investment decisions?

One of the hassles of investing in a regular brokerage account is taxes. Every time that you receive a qualified dividend, you have a taxable liability to Uncle Sam if you are in the 25% tax bracket or higher. Every time that you sell a stock at a gain you also have a taxable liability. If you sell the stock at a loss, you have a tax asset, a portion of which could be deferred for several years.

I try to minimize tax liabilities as much as everyone else. However, my primary focus is to make as much dividends and capital gains as I can, and only then worry about taxes. I approach each investment asking myself, would this investment provide enough rising dividend income, so that one day I can afford to live off my nest egg? I do not ask myself first, would this investment save me on taxes. However, if I can save on taxes, while also earning good investment returns, it might be worthwhile to let taxes be part of the investment decisions. On the other hand, making an investment merely for the tax benefit or loss, without thinking whether the investment itself makes sense, is an example of a scenario where taxes should not guide my decisions. So to answer the title of this post, it depends. This article will explore different angles of this issue. I will try to put actual examples from my own investing to illustrate various scenarios. They are of course not inclusive of all possible situations.

The tax code is very large, complex and growing. This is why tax services are a multi-billion dollar industry. As a result, you won’t get the nitty-gritty detail information from this single article. However, I am going to outline my overall philosophy on taxation in guiding investment decisions.

I try to legally minimize taxes as much as I can. However, the tax code is set up in a way that in order for you to minimize taxes, you have to jump through hoops. You then also have to jump through hoops in order to access the money.

For example, earlier last year I started maxing out SEP IRA and 401 (k) contributions, in an effort to minimize tax liabilities and end up with “more money” to generate a higher level of dividend income. I was able to “save” a much higher amount of money, because of lowering my taxes. By placing $10,000 in a 401 (k), I am essentially ending up with the amount in the 401 (k), plus a tax credit of approximately $3,000 that I can then use to place in a Roth IRA. In addition, these funds would grow tax-free through the time I am 70 ½ years old (assuming I make it that far).

Unfortunately, these “savings” came at a price. The price I am paying is that I cannot easily withdraw the money penalty free without jumping through hoops such as attaining the age of 55 for 401 (k) plans or 59 ½ years for IRA’s. If I were 45, and decided to start taking money out of my retirement accounts, I would have to pay a 10% early withdrawal penalty, in addition to paying ordinary income taxes. Once I do retire at whatever age however, I can do Substantially Equal Periodic Payments, and withdraw a portion of dividend income generated (or a small percentage of assets invested) every year without paying the 10% penalty. If I have enough coming in dividends from taxable accounts however, I would just let the tax-deferred assets compound. Check out rule IRS 72 (t), for more information. Or I could simply retire early, drop my tax bracket to the lowest percentile possible, and rollover the 401 (k) and IRA into a Roth. Thus, I would get a tax deduction today, and then pay minimal if any taxes, if I am smart about slowly rolling over those money into a Roth and never having to pay taxes on it again. Any amount of money rolled over from a pre-tax 401 (k) into a Roth IRA can be withdrawn after five years, penalty-free, at pretty much any age. This is called a Roth IRA Conversion Ladder.

Another price I am paying in my 401 (k) is that my options are limited to very low cost index funds. I believe that a portfolio of dividend paying stocks would likely generate total returns that are very close to those of an index fund such as S&P 500 or Dow Jones Industrial's Average over time. However, I am better off investing in index funds in an 401 (k) than paying a tax, and investing the money in individual dividend paying companies. This means that instead of buying several dividend paying stocks every month, I would have to resort to buying only a few dividend stock on average every month. In a few years when I retire however, or if I switch employers, I should be able to roll the money into an IRA, and convert index funds into individual income stocks. If I don't need the money in tax-deferred accounts, I will let it compound tax-free for decades.

The other price I am paying is that if I become overconfident in my abilities, and end up doing stupid investments in IRA’s and I lose almost everything, I would not get any tax benefit. If I have a $500,000 portfolio, and lost $500,000 on it, I would be able to offset any future capital gains against those losses in a taxable account. However, in a tax-free account, I would get no tax benefit. I honestly doubt however that I could lose 100% of an investment in a diversified portfolio of quality dividend growth companies, which sends cold hard cash my way every 90 days.

The other point I would try to make in this article is that taxes by themselves should never guide your investment decisions. The issue with this statement is that by ignoring your investment rules, through focusing on taxation, you can be taking on risks that are not quantifiable at the time of your investment decision. By placing a higher priority on taxable outcomes, at the expense of your investments, you might find yourself overlooking valuable facts that could cause you to pay dearly. By investing in very low cost index funds, I am still putting money in a very diversified portfolio of the largest US companies and will generate a total return that is very close to that of a portfolio of dividend paying stocks. Thus, I do not believe this to be an example of only focusing on taxes, while throwing sound judgment out the window. If however, my 401 (k) only offered funds with high loads, and high annual expenses, I will probably not invest more than the amount needed to get the 401 (k) match.

The thing is, you can easily calculate how much you are giving up or how much you are gaining by modifying your investment decision to fit taxable rules. However, you can never calculate with precision the actual risk you are taking in doing so.

For example, assume you purchased shares in Citigroup (C) in July 2007. In January 2008, the company cuts dividends but you do not sell, because it would “complicate your taxes”. The stock proceeds to lose money for you. You would have been better off complicating your taxes and getting something out, rather than do nothing and be worse off after all. This was an actual example from an acquaintance of mine, who worked at a company whose stock dropped by 90-95% between 2007 and 2009. We had discussions about selling that stock in 2007, but the main argument was that complicating tax scenarios was not worth the trouble. Personally, I find losing over $1,000 to be a much larger "trouble", but that is just me.

In another example, assume that you purchased shares in a company which you believe has very good long-term prospects. However, you turn out to be wrong, and eleven months later you decide to sell after a dividend was cut. Surprisingly, you still have a small gain. However, you do not want to sell, because your gain will be taxed at ordinary rates. You do not want to be a “sucker”, and decide to patiently wait for another month, in order to get preferential tax treatment. If the stock price drops from there, you won’t have to worry about getting preferential tax treatment on the first $3,000 of losses. You will be able to carry forward and deduct any excess over $3,000 in losses you have in the future, reminding you about overruling your strategy. If the stock price actually increases however, you might end up patting yourself on the back for a job well done. You learned a valuable lesson that you can override your rules. The problem is that if you frequently override your rules, it might create a slippery slope that could cost a lot in the future. Or it could mean that you are skilled and know what you are doing. After all, some of the best investors in the world do not have a rigid set of rules, but tend to be more principles based. You never hear Buffett quantify the maximum entry price he is willing to pay for companies. Of course, if you are as good as Buffett, chances are that my writing is not for you.

For example, I bought some shares of Universal Health Realty Income Trust (UHT) in 2012. However, when the price was very inflated in March - April 2013, I sold it and realized an ordinary gain. I am much better off doing so, because the valuation was above intrinsic value, and I could redeploy that money into more attractively priced REITs. I realized buying and holding on to UHT was a mistake to begin with, because the growth in distributions was really terrible. While it might have made some sense to buy a company yielding 6% and growing dividends at 2%, things change when it yields close to 4% and grows dividends at 2%.

In another example, I do pay attention to taxes in situations where I can get a tax benefit, without sacrificing investment quality. A prime example of that is my investment in Unilever, which has two tracking stocks, one of which I have held on for many years. I hold shares in Unilever PLC (UL), rather than shares of Unilever N.V. (UN). Both those shares offer the same economic interest in the company Unilever. However the dividends of the former (UL) are not subject to a foreign withholding tax to US investors, because they are treated as British dividend income. Due to tax treaties between US and UK, dividend income derived from British companies and paid to US shareholders is not subject to a withholding tax. This makes it ideal for US investors who want to own Unilever in both taxable or tax deferred accounts, and not have to worry about further complicating their tax returns. On the other hand, if you invest in Unilever N.V. (UN), your dividend income will be subject to a 15% withholding tax at the source. Luckily, Uncle Sam provides a tax credit for this withholding amount, but why complicate your already busy life? Plus, you do not want to stick companies that are subject to a foreign tax in retirement accounts, since there is no way to get a credit for them. My investment in Kinder Morgan Management LLC (KMR), rather than Kinder Morgan Energy Partners (KMP), was another example where I had the opportunity to obtain the same economic interest in a partnership, but at a discount and without increasing complexity for my taxes.

In conclusion, to answer the question asked at the title of this article – it depends on the specific situation. If the choice is between dividend growth investing in a taxable account, or index funds in a 401 (k) plan that come with significant tax savings, it makes more sense to go with the latter. If I have to choose between different classes of the same security that offer different tax outcomes, like in the case of UN vs UL, I would always go for the simpler tax structure. However, if I decide not to invest in a company because “taxes are more complicated”, or postpone selling so as not to complicate taxes when the business is obviously a mistake, I am doing it wrong.

Full Disclosure: Long KMR, UL,

Relevant Articles:

My Retirement Strategy for Tax-Free Income
Dividends Provide a Tax-Efficient Form of Income
Kinder Morgan Partners – One Company three ways to invest in it
Roth IRA’s for Dividend Investors
Six Dividend Paying Stocks I Purchased for my IRA

Wednesday, July 23, 2014

Surprise: The real cost of inversions are paid by shareholders

There are several companies I own, which are trying to do a corporate inversion, in an effort to renounce their US corporate citizenship. This inversion is achieved when a US based company buys a foreign corporation, and as a result moves its legal domicile in the foreign country. As a result, the new combined company would be treated as a non-US company in the eyes of the US tax authorities. This is appealing to companies, because they would only owe US income taxes on income derived solely from US operations.

Under current laws and regulations, US companies that earn money abroad have to pay steep tax bills if they were to repatriate those funds to the homeland, in order to pay dividends, buy back stock or invest in the business. Once an inversion is complete however, these companies would not owe any taxes on income that is earned from foreign operations. As I discussed earlier, most of the companies that dividend investor tend to buy earn a very high percentage of revenues from abroad. This is the nice thing about owning a solid blue chip, which sells branded products and services around the globe, and earns more money to pay higher dividends to you over time.

There are some details that need to be met in order to do this inversion, such as the fact that at least 20% of shareholders of the new company need to be foreign, but this is not the point of this article. The important thing to remember is that inversions generally help reduce the tax rates of companies. From a tax perspective, if you are a US company and your top income tax rate is 35%, it does make sense to relocate to Ireland and pay a tax rate of 12.50%, if you can get away with it. This is essentially what an inversion does.

As a shareholder, less expenses translates into more earnings per share. In addition, cash that is locked abroad for so many US companies that do business internationally will now be easier to access for dividends, share buybacks, investment in the business. Furthermore, if the company relocated to a place like UK for example, dividend income is not subject to any withholding taxes to the US investor. Hence, those shares could still be held in tax-deferred accounts such as IRA’s. So at first glance, it seems like inversions are a good thing to shareholders of the acquirer, since they will result in higher earnings per share, and the possibility for higher dividends and share prices as a result.

As I dug deeper however, I learned that there is a tax that ordinary shareholders like you and me have to pay on inversions. When the tax inversion occurs, shareholders of the acquirer will be treated as if they sold their stock and then purchased the stock in the new, “inverted” company. This creates a taxable event, which means that investors would have to pay a tax on their gains. If the price at which investors acquired their shares was higher, then they might end up deducting losses. In the cases of Medtronic (MDT) and Abbvie (ABBV) however, I believe that most long-term investors are sitting at nice unrealized gains. The only consolation is that stock basis would be stepped up after this exercise. However, the forced tax leakage would be costly for long-term investors like me.

My cost basis in companies like Abbvie (ABBV), Medtronic (MDT) and Walgreens (WAG) is around 2 times lower than current prices ( I have been acquiring shares in each of the companies and their predecessors between 2008 and 2013). Only a small portion of my positions in each company is in tax-deferred accounts. For example, my basis in Abbvie is $29.43/share, while my basis in Medtronic is around $35/share.

I try to seldom sell, because I have to pay taxes. This reduces amount of money I have working for me. By not selling, I have a deferred tax liability to the IRS, which I hope to never pay. This is money I owe, but I don’t pay interest on. This is essentially float, that further helps me achieve financial freedom. It also means I have more money compounding for me. If I sell, I pay tax, and have less money to invest. The opportunity cost of a dollar paid in taxes, that grows by 10%/year for 50 years is $117. At a 3% yield, this is almost $3.50 in income in 50 years, for each dollar I put to work today. That is $1 less working for my descendants or my charitable causes.

These are not good news for any long-term holders like me, who have low tax bases. This is another reason I am trying to max out any tax-deferred accounts, in an effort to shield as much of my money from the crippling effect of annual taxes on my capital gains and dividends. Those friction costs do cost money, that means less money available for my dividend machine to use for its compounding purposes. Either way, over time, expansion of a business is good, since synergies are achieved, taxes are lowered, and this improves the earnings capability of the business. This increases the worth of the business, and the ability to pay higher dividends over time. The ability to pay dividends is further increased by the ability to access cash stored abroad at ease. So the net effect could be positive of course for the patient long-term holder. The effects would be really positive for the patient long-term holder, who placed their shares in a tax-deferred vehicle such as a Roth IRA.

I guess I am learning something new every day. Today is no exception. I thought this was a good deal for shareholders, since corporate taxes will decrease, which increases EPS, and allows companies to be able to access cash abroad for purposes of higher dividends and buybacks. However, this has to be weighed against the tax hit which many long-term investors are facing. What is really bad is the fact that most stock is owned through mutual funds, which do not care about many things such as corporate governance, taxes etc. For those who believe index funds are the way to go, you are one of the reasons why corporate managements think they can do what they want to do. When you have passive owners, who do not believe “active management” produces alpha, you are setting up really perverse incentives for management on executive compensation, corporate strategy, short-term thinking etc.

Hat tip to a reader in France, for alerting me to this topic.

Full Disclosure: Long ABBV, MDT, WAG

Relevant Articles:

My Retirement Strategy for Tax-Free Income
Dividends Provide a Tax-Efficient Form of Income
Roth IRA’s for Dividend Investors
Why should companies pay out dividends?
Dividends versus Share Buybacks/Stock repurchases

Wednesday, January 15, 2014

My Dividend Goals for 2014 and after

With the end of 2013, many dividend investors are reviewing the year that passed, and are updating their 2014 goals. As I am reviewing results from my portfolio, I am trying to understand if I am on track to reach my goals.

The three inputs that will help me achieve my goals are organic dividends growth, reinvestment yield and new capital to invest. In my book, organic dividend growth is merely a result of corporations approving increases in distributions to shareholders. I strive for a 6% in annual dividend growth on average. Since I am in the accumulation phase of my dividend investing journey I am also reinvesting dividends into more income producing securities. I believe that if my portfolio keeps growing distributions by 6 – 7% per year, and I reinvest this cashflow back into more dividend paying stocks yielding 3- 4% today, I can essentially grow total dividend income by approximately 10% per year.

This of course assumes that I no longer put any new capital to work in dividend paying stocks. The biggest change I implemented in 2013 was to reduce the amount of contributions to my taxable accounts to the minimum. This was because I am starting to max out tax-deferred accounts such as 401 (k), Sep IRA and Roth IRA, in order to cut down on taxes today, and create a vehicle where I would generate dividend income that won’t be taxed for at least 30 – 40 years. When you put money in taxable accounts, you can withdraw dividends from one account and easily pool them into another account. Unfortunately, with tax-deferred accounts, the money generated in one account has to stay there. I am doing this, because my largest expense in my budget is taxes. This includes Federal, State and FICA taxes.

My taxable accounts would likely generate a sufficient stream of income to reach my dividend crossover point within five years. This would be as a result of organic dividend growth, dividend reinvestment and fresh additions of investable funds. I do believe that I need to be generating more in dividends than what my regular monthly expenses are, just to be on the safe side. Because I would be earning more than what my typical monthly expenses would be, I would be paying taxes on the buffer income I won't be using. Therefore, I have added the assets that would generate this dividend income buffer in tax-deferred accounts. I would have to jump through hoops in order to access these funds, which is why I would only tap them in the case of extreme circumstances. There is a high likelihood that these funds would not need to be used ever, but could provide a potential buffer in case I am wrong in my calculations. Plus, the money would compound tax-free for decades, before the tax person gets their share, if I do not need to use them.

Now that I provided some high-level background on the status of accounts, I am going to go over my goals for the next few years. As I had mentioned before, I plan on becoming FI by 2018. After looking at the numbers, it looks as if I am on track to reach this goal. I am currently able to cover approximately 60%-65% of expenses with dividend income. This is a slight improvement from 50% – 60% that I was able to cover in early 2013. Using a conservative 10% growth in total dividend income, I come up with the following calculations:

Expenses Covered by Dividends

The table shows percentage of monthly expenses that are covered by dividend income at year end. I have simply compounded the percentage of expenses covered by dividends by 10%/annum. It looks like I am on track right now to accomplish my goals. I prefer to discuss goals in terms of the longer-term goal, rather simply focus on isolated annual goals. I think that for 2014 I would strive for approximately 70% in dividend income coverage, but this is meaningless without understanding how this goal fits in the grand scheme of things.

The percentages in the table do not include dividends generated in tax-deferred accounts. I expect that most of my future contributions will be in tax-deferred accounts, which would hold the excess dividend income, that would be part of my safety net. Some portions of income will make their way to taxable accounts, which might increase the percentage of expenses covered by dividends. However, in order to be conservative in my assumptions, I am not going to change these estimates in the table above.

I am also not putting down exact dollar figures, because reasonable expenditures vary from individual to individual. For example, for a single individual living in the Midwest that owns their residence, they can probably get by on say $1,500/month. However, if you are a married couple that lives in New York City or San Francisco, you would likely need at least $4,000 - $5,000/month merely to get by. The goal of this article is not to debate whether a certain dollar figure is reasonable or not, but to discuss my thought process in getting to a reasonable goal within a reasonable time. After all, these are my numbers, and they make sense for me - your numbers are going to be much different.

Therefore, in order to get to a place, you need to determine what your goal is. Write it down, and then try to determine how to get to that goal. I figured out early that I would achieve my goal with my diversified portfolio of dividend growth stocks, which are companies that regularly boost distributions for shareholders. I then determined the monthly amount I plan to invest each month, and also determined reasonable assumptions about returns. Based on these assumptions, I then figured out the amount of time I would need in order to get there.

It is also important to have a plan B and even plan C in action, in case your assumptions don’t turn out as expected. The value of a job income cannot be overlooked. For example, a source of $100 in monthly income is equivalent to $30,000 - $40,000 invested at 3%- 4%. This should be something you enjoy however, and are passionate about. So if you enjoy doing taxes and learning how much others make – you might be a tax preparer between January and April every year. It is up to you to figure out what you can do. However, I am not going to tell how to spend your time in retirement, so I am going to end the discussion here.

One obstacle to my plans could include situations where I lose my primary job, and am unable to find another one after that. This could damage my ability to make future contributions, and would also prevent me from reinvesting distributions, as I would be using them for my day to day expenses. Another obstacle that could prevent me from achieving my goals include situations where I can find fewer securities that fit my entry criteria. After a relentless increase in 2013, it is getting to a point where quality dividend companies are tougher to find. I do not envy the dividend investor who is just about to start putting their hard earned money to work today.

However, all hope is not lost, as I do find quality at decent prices today. The types of companies that look priced fairly include:

McDonald’s Corporation (MCD) franchises and operates McDonald's restaurants in the United States, Europe, the Asia/Pacific, the Middle East, Africa, Canada, and Latin America. This dividend champion has increased dividends for 38 years in a row. Over the past five years, it has managed to raise them at a rate of 13.90%/year. Currently, the stock trades at a P/E of 17.30 and yields 3.40%. Check my analysis of McDonald'’s for more information.

Philip Morris International Inc. (PM), through its subsidiaries, manufactures and sells cigarettes and other tobacco products. This dividend machine has increased dividends for 5 years in a row. Over the past five years, it has managed to increase quarterly dividends by 15.40%/year. Currently, the stock trades at a P/E of 15.70 and yields 4.60%. Check my analysis of Philip Morris International for more information.

Chevron Corporation (CVX), through its subsidiaries, engages in petroleum, chemicals, mining, power generation, and energy operations worldwide. This dividend champion has increased dividends for 26 years in a row. Over the past five years, it has managed to raise them at a rate of 9%/year. Currently, the stock trades at a P/E of 9.90 and yields 3.30%. Check my analysis of Chevron for more information.

Target Corporation (TGT) operates general merchandise stores in the United States. This dividend champion has increased dividends for 46 years in a row. Over the past five years, it has managed to raise them at a rate of 21.40%/year. Currently, the stock trades at a P/E of 16.70 and yields 2.70%. Check my analysis of Target for more information.

Wal-Mart Stores, Inc. (WMT) operates retail stores in various formats worldwide.This dividend champion has increased dividends for 39 years in a row. Over the past five years, it has managed to raise them at a rate of 14.20%/year. Currently, the stock trades at a P/E of 15 and yields 2.40%. Check my analysis of Wal-Mart for more information.

Full Disclosure: Long MCD, PM, CVX, TGT, WMT

Relevant Articles:

Complete List of Articles on Dividend Growth Investor
The Security I Like Best: Philip Morris International
Dividend Investing Goals for 2013
My dividend crossover point
My Retirement Strategy for Tax-Free Income

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