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

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:


Year
Expenses Covered by Dividends
2013
60%
2014
66%
2015
73%
2016
80%
2017
88%
2018
97%

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

Wednesday, December 11, 2013

Dividends Provide a Tax-Efficient Form of Income

A famous saying goes that there are two things certain in this world: death and taxes. While I am pretty sure I can’t escape death, I know that I can try to legally minimize taxes as much as possible. I hate paying more taxes than I have to. In a previous series of articles I discussed how I am maxing out tax-deferred accounts today, in order to minimize my tax liabilities as much as possible. In addition, I am trying to get a deduction today, and then roll these amounts into Roth and try to pay as close to zero percent on the conversion as possible. The amounts in tax-deferred accounts will be the tip of the iceberg, or the “safety net” in case my main strategy experiences turbulence. In effect, these tax-deferred accounts are equivalent to an emergency fund for my retirement.

However, I think I didn't stress enough the fact that most of my income in retirement would be coming from qualified dividends. This will be my bread and butter, because dividends provide the best tax-efficient method of income in the US.

Did you know that if you were single, and your taxable income does not exceed $36,250 in 2013, you would owe zero dollars in Federal taxes on your qualified dividend income? If you were married, filing jointly, you won’t owe a dime in taxes on qualified dividends at the Federal level as long as your taxable income does not exceed $72,500.

This means that if you are single, living on your own, and only claiming yourself as a dependent, you can essentially make $46,250 in annual qualified dividend income, and pay zero taxes on that. This includes the Standard Deduction of $6,100 and the Personal Exemption of $3,900. This calculation also assumes you have no other sources of income and no other deductions for the sake of simplicity and to illustrate the point. In order for you to generate so much in income, your portfolio would likely be worth anywhere between $1.321 million and $1.542 million at yields between 3% – 3.50%. If you made your selections wisely, your dividend income should at least keep up with inflation over time. With most dividend growth stocks, I expect a 6% annual dividend increase in the long run, ahead of the annual inflation rate of 3%.

This net dividend income for the single individual above is equivalent to $58,900 in salary earnings. In other words, if you are single, it would take you to earn $58,900 from a day job in order to end up with the same amount of net income that the same individual can achieve with “only” $46,250 in qualified dividend income. And you were wondering why Warren Buffett’s secretary is so vocal about her bosses taxes.

Let’s see how this translates for a married couple, filing jointly, without any kids, mortgages and student loans. They could essentially earn $92,500 in annual qualified dividend income, before owing a single cent to the Federal government in 2013. This includes two standard deductions and two personal exemptions in the tax return. In order for this couple to generate so much in income, their dividend growth portfolio would likely be worth anywhere between $2.643 million and $3.083 million at yields between 3% – 3.50%.

This net dividend income for the married individuals above is equivalent to $117,800 in salary earnings. In other words, if you are married with no children, it would take the couple to earn $117,800 from a day job in order to end up with the same amount of net income they can achieve with “only” $92,500 in qualified dividend income.


For the sake of simplicity, and to illustrate a point about the tax efficiency of dividends, I have compared salary only income versus dividend only income. The tax code is so complicated, that it would probably take me years and hundreds of pages before I can explain every single possible scenario affecting those sample single and married individuals.

I claim that the dividend income is the most efficient form of income in the US, because it can increase over time to compensate for inflation. With municipal bonds, you do not pay any income tax, no matter how much you make. However, since your income is fixed, your “real” purchasing power is decreasing over time. As a result, you are worse off than with dividend stocks over extended periods of time.

I should also mention that ordinary dividend income is taxed like ordinary income. Luckily, this type of dividends are not taxed at the FICA level. Examples of ordinary dividend income includes the income sent your way by Real Estate Investment trusts, net of any depreciation for example. Each REIT has a different tax picture, which also varies every year. I didn’t include these into my scenario above, because I didn’t want to overly complicate something that was already complicated. But feel free to play it out safely at home. If you do not believe me, you can check the website of National Retail Properties (NNN) at this link.

I purposefully also avoided included MLP distributions, because these are even hairier at tax time. These distributions might not even be taxable to you as long as your cost basis is above zero.

Foreign dividends are another type of income which is taxed usually as qualified dividends. The twist is that some governments withhold the tax at the source, which entitles you to a credit. Therefore, if you paid $15 in dividend taxes to Canada on your $100 dividend check from Canadian National Railway (CNI), you don’t also have to pay Uncle Sam $15 additional dollars in dividend income. You can essentially get a credit for this. If you are single earning under $46,250 in dividend income, you might even get a check in the mail for $15.

Full Disclosure: I am not a tax advisor, and this article should not be considered as individual tax advice. Please discuss your individual tax situation with a licensed CPA. I have no position in the companies listed above.

Relevant Articles:

Best International Dividend Stocks
My Retirement Strategy for Tax-Free Income
How to Retire Early With Tax-Advantaged Accounts
Six Dividend Paying Stocks I Purchased for my IRA
Should income investors worry about higher dividend taxes?

Monday, December 2, 2013

Nine Quality Dividend Stocks Purchased for the Roth IRA in November

Back in September, I started making contributions for my Roth IRA. I bought shares the following ten companies in September, these nine in October, and a few more in November. The purpose of this series of posts is to prove that it is possible to create a diversified dividend portfolio even if you do not have a lot of starting capital, while also keeping costs as low as possible. The low costs were possible because I used Sharebuilder, which allows you to make 12 purchases per month for $12. The first month after you sign up is a trial month, meaning that all twelve transactions are free. Therefore, if you make 12 trades/month for three months, the most you are going to pay is $24. That comes down to less than 0.50% of the investment amount, if you contribute the 2013 maximum contribution of $5,500. If you were putting more money than that to work however, the initial set up cost would be an even much lower percentage.

The more challenging part of the portfolio building process was uncovering quality dividend stocks, which were also attractively valued. Given the fact that stocks are hitting all-time-highs every day, it is difficult to find quality companies that are not overvalued.

As a result, I was able to purchase shares in the following dividend paying companies in November:

Philip Morris International Inc. (PM), through its subsidiaries, manufactures and sells cigarettes and other tobacco products. The company has consistently raised dividends since being spun off from parents Altria Group (MO) in 2008. Over the past 5 years, PMI has managed to boost distributions by 13%/year. The company is really cheap at 16.20 times earnings and yields 4.40%. This is my second largest holding, which is why it does not make sense from a diversification standpoint to keep adding money there for me. Check my analysis of Philip Morris International.

General Mills, Inc. (GIS) produces and markets branded consumer foods in the United States and internationally. I initiated a small position in the stock. This dividend achiever has raised distributions for 10 years in a row. Over the past decade, General Mills has managed to boost dividends by 8.70%/year. The company is selling for 17.40 times forward earnings, and yields 3%. Check my analysis of General Mills.

Target Corporation (TGT) operates general merchandise stores in the United States. This dividend champion has raised distributions for 46 consecutive years in a row. Over the past decade, Target has managed to boost dividends by 18.60%/year. The company is selling for 17.20 times earnings and yields 2.70%. The big opportunity behind the company is international expansion, which could reward shareholders immensely, if it is done right. Check my analysis of Target.

Exxon Mobil Corporation (XOM) engages in the exploration and production of crude oil and natural gas, and manufacture of petroleum products. This dividend champion has raised distributions for 31 years in a row. Over the past decade, Exxon Mobil has managed to raise dividends by 9%/year, and has also managed to repurchase stock consistently for decades. Currently, the stock is trading at 12.25 times earnings and yields 2.70%. The stock popped on news Warren Buffett initiated a large position in it, which is why adding to Exxon on dips might be a good strategy. Check my analysis of Exxon Mobil.

The Toronto-Dominion Bank (TD), together with its subsidiaries, provides financial and banking services in North America and internationally. The stock is selling for 13 times earnings and yields 3.60%. The company started raising dividends in 2011, after freezing them in 2008.

Royal Bank of Canada (RY), a diversified financial service company, provides personal and commercial banking, wealth management, insurance, corporate and investment banking, and transaction processing services worldwide. The stock is selling for 12.10 times earnings and yields 3.90%. The company started raising dividends in 2011, after freezing them in 2007.

Canadian Imperial Bank of Commerce (CM) provides various financial products and services in Canada and internationally. The stock is selling for 10.20 times earnings and yields 4.30%. The company started raising dividends in 2011, after freezing them in 2007.

The Bank of Nova Scotia (BNS), together with its subsidiaries, provides various personal, commercial, corporate, and investment banking services in Canada and internationally. The stock is selling for 12 times earnings and yields 3.90%. The company started raising dividends in 2011, after freezing them in 2008.

Bank of Montreal (BMO), together with its subsidiaries, provides various retail banking, wealth management, and investment banking products and services in North America and internationally. The stock is selling for 11 times earnings and yields 4%. The company started raising dividends in 2013, after freezing them in 2007.

Overall, I am very bullish on Canadian banks for the very long term. None of the five largest Canadian banks cut dividends during the financial crisis, although they did freeze them for a few years. I think that the Canadian economy is in a unique position to deliver population growth, economic growth, that would trickle down to bolster long-term earnings for the largest banks in the country. This is a bet that Canada in 50 years will be very prosperous, which would trickle down to huge amount of rising dividends from those banks. In addition, while Canadian dividends face a 15% withholding for taxable accounts, there is no withholding in retirement accounts such as Roth IRA's. I plan on writing an article specifically outlining my thesis behind a core long-term holding of these five Canadian banks. Please stay tuned.

UPDATE 2/5/2014 : Sharebuilder is still withholding Canadian taxes on dividends, despite the fact that it is in a ROTH IRA. They seemed unwilling to accommodate my needs as a client, which is why I would not recommend them for buying Canadian dividend paying stocks in tax-deferred accounts.

With this, my allocations for 2013 Roth IRA are complete. I would wait to make my 2014 Roth IRA, until I make my SEP IRA contributions in the first quarter of 2014. Given the fact that I am trying to put away as much as possible in tax-deferred accounts, ( 401K, Sep and Roth IRA’s), I am not going to be able to make as many investments in taxable accounts as before. Therefore, my dividend income would grow merely as a result of organic dividend increases and dividend reinvestment. I expect this to lead to a 10% annual increase in dividends for the next five years. Let’s see if this can be done.

Full Disclosure: Long all companies mentioned in this article

Relevant Articles:

Check the Complete Article Archive
Why Warren Buffett purchased Exxon Mobil stock?
Roth IRA’s for Dividend Investors
Six things I learned from the financial crisis
My Retirement Strategy for Tax-Free Income

Friday, October 25, 2013

My Retirement Strategy for Tax-Free Income

This is the last article on taxes for the week. Hopefully you enjoyed articles one, two, three and now four. Please make sure to read the other three articles, before checking this one, because it is a continuation of them all.

In my retirement strategy, I currently have the bulk of my funds in taxable brokerage accounts. They are producing approximately enough dividend income to cover 50 - 60% of my annual expenses. As I am maxing out 401 (k), Sep IRA and Roth IRAcontributions this year, this leaves less to be put towards my taxable dividend portfolios. The tax savings are more than worth it however. If I were a fan of Early Retirement Extreme and worked for 4 years, while saving $17,500/year in a 401 (K), the tax benefits would be equivalent to me working over one whole year. I would end up with a total of $17,500 in savings in a taxable account merely because of my marginal tax rate of 25%. This is in addition to having the contributions for four years in the 401 (k).

I expect to be able to not have to work in a traditional job environment by the end of 2018. By this time, my dividend income would likely be covering 100% of my expenses. This is because I expect dividend growth of 6 – 7% in my dividend portfolio, which continues to be reinvested in dividend paying stocks whose average yield is somewhere in the 3% - 4% range. Currently, it covers approximately 50 – 60% of expenses.

I am also expecting that I would earn some money on the side in a 1099 capacity after my retirement date, although I am not counting on it. Of course, if I have all the free time in the world, chances are I could write a book on dividend investing, start a stock picking paid service, create and run a low cost dividend mutual fund or start a TV show on dividend investing ( to name a few possible items). Or I could get really bored and start advising persons on financial and tax matters for a fee. This extra income however, would not be spent but merely end up accumulating. Since I would consider myself retired, and already have dividends covering my income, this would mean that some of my assets would need to be put in a tax deferred account today. Otherwise, I would be drowning in cash, and would be paying too much to the tax person for years. For example, if I make $24,000 in annual dividend income, and $24,000 in contracting income, but only need $24,000 to live on, I am essentially earning too much. If I made the dividends in a tax-deferred account, I could therefore choose to withdraw them as I please (or as I need the money to live on). It doesn’t make sense to pay taxes for dividend income I am not using, especially if it is in a taxable account. In a tax-deferred account, the money will compound tax-free for decades.

Therefore, the optimistic scenario is that I max out contributions and keep the 401 (k), Sep IRA and Roth IRA to compound tax-free for several decades. If I do not make too much money from dividends and side hustles once I retire, but enough to live on, I would start rolling over portions of my 401 (k) into a Roth IRA. I would try not to pay more than a 15% tax on that rollover. I expect that within 3 – 4 years after retirement, I should be able complete the conversion process. After that, I might also consider rolling any IRA and Sep IRA accounts over to Roth, depending on balances and my tax situation.

However, if I end up making too much from my dividend stocks and side hustles, I would likely have to simply roll those 401 (k) amounts into a regular IRA, and slowly convert it into a portfolio of dividend paying stocks. I expect it to compound tax-free for several decades, until I reach the age of 70.50 years old and have to take required minimum distributions. Since I have several decades before I hit that age, this could potentially be a large tax hit. Of course, I would much rather use any trick under my sleeve to accumulate as much cash as I can to generate as much dividend income, in order to achieve my goals of retiring early. The trade-offs are well worth it.

This is because it is much better to accumulate $17,500 in a 401 (k) in a single year, rather than accumulate only $13,125 in a taxable account for the year. In addition, I am somewhat protected from increases in tax rates on the amounts that would stay inside tax-deferred accounts. If tax rates on dividends and capital gains increased to match ordinary income rates, this could be bad for retired dividend investors. Of course, I do not know where tax rates are going to be 30 – 40 years from now, which is why I try to diversify against the risk of higher taxes by shifting some of my assets to tax deferred types of accounts.

Last but not least, I fully expect my taxable accounts to be able to cover my expenses in 4 - 5 years based on current levels, and projections for reinvestment at yields of 3 - 4 % and dividend growth of 6 - 7 %/year. The excess is going to tax deferred accounts ( 401K, Sep IRA and Roth IRA), which would likely be able to cover somewhere between 25% - 33% of expenses above 100%. This would be the reserve account in case my dividend income does not grow at or above the rate of inflation or if I experience too many dividend cuts for whatever reason. Another reason for the reserve is that I might end up spending more than I initially projected. Since I am hoping not to have to touch this "reserve fund" unless something unexpected happens, it is much better to be in a tax-deferred account, and it won't generate tax liabilities on income i don't need.

After reading all four articles on tax deferred accounts, I hope you learned the general overview of options available to you outside of taxable accounts. I also hope my take was helpful.

Full Disclosure: None

Relevant Articles:

Why I Considered Tax-Advantaged Accounts for My Dividend investing
Is Dividend Mantra Wrong on Taxes?
How to Retire Early With Tax-Advantaged Accounts
Do not despise the days of small beginnings
Price is what you pay, value is what you get

This article was featured on the Carnival of Wealth

Thursday, October 24, 2013

How to Retire Early With Tax-Advantaged Accounts

This is the third article on my series on how to retire early with tax-advantaged accounts. Be sure to check the first article and the second article, before reading this one, as it is a continuation of my ideas already presented there. Stay tuned for the fourth article later on this week.

With 401 (k) accounts, you can withdraw money penalty-free after the age of 55, penalty free. With IRA and Roth IRA accounts, you can withdraw money penalty-free after the age of 59.5 years. You can withdraw only contributions but not earnings from Roth IRA without penalty before the age of 59.50 years. Otherwise, a 10% penalty applies, unless Substantially Equal Periodic Payments (SEPP) are selected.

If you choose to retire early, but you have found an accidental income source that pays for your bills, you might decide that you can simply leave your tax-deferred accounts there to grow tax free for decades. This would be interrupted by age 70.5, when you would have to pay required minimum distributions for 401 (k) and IRA's, which increase as you age. As a result, it might make sense to roll-over some of that 401 (k) or IRA money into a Roth IRA. When you do that, you might have to pay ordinary income taxes on the amounts you convert to a Roth IRA. You can also, convert just a portion of your 401 (k) or IRA balance over to a Roth IRA, in order to minimize the tax hit.

For example, lets assume you needed $24,000 to live on annually, and you manage to somehow earn that in your retirement years from side-gigs. Let's assume that you have $50,000 in your 401 (k) plan. If all else is equal, you can essentially convert approximately $12,500 from your 401 (k) into a Roth IRA for four years in a row, and end up paying a 15% marginal tax rate on the conversion amount. The distributions from your Roth IRA will grow tax-free for as long as you live, and you would never have to withdraw them. Once you are eligible to withdraw them however after the age of 59.5 years old, the distributions would be tax free.

This means that if you contributed to a 401 (k) or a tax deductible IRA and you were paying more than a 25% tax at the Federal level, it would be very beneficial to convert to a Roth IRA, especially if you can pay a tax rate that is much lower than 25% on the conversion. Your money will grow tax free in the Roth, you would have the option to buy US securities traded on NYSE, Nasdaq or Amex, and your distributions would be essentially tax free when you are eligible to withdraw them.

There is also an exception related to Roth IRA accounts, when you made a conversion from a regular IRA or a 401 (k) and paid taxes on the converted amount. You can essentially withdraw the amount of the contribution you made to the Roth at the time of conversion after five years from the conversion. For example, if you converted a $1000 IRA into a Roth in 2000, you can withdraw that $1000 tax-free in 2006.

With a Roth IRA, you can essentially put up to $5,500 per year, if you are under the age of 50. This money grows tax-free for decades, and you never have to distribute it. When you are eligible to distribute all the money from the Roth ( typically after you are 59.5 years old), you won’t owe any taxes on it. There is also this nice little thing about Roth IRA’s, where you can withdraw your contributions, but not earnings, prior to age of 59.50 years old, without paying any penalties. The real issue with regular Roth IRA’s is that it would take at least 10 – 15 years, before you can accumulate $100,000 in your account. Therefore, the way to attain critical mass with this account is through a rollover of a 401 (k), regular IRA or through a long period of contributing.

Check my last article on the topic.

Full Disclosure: None

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Why I Considered Tax-Advantaged Accounts for My Dividend Investments
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Wednesday, October 23, 2013

Is Dividend Mantra Wrong on Taxes?

This is the second article in my three-article series on deferring taxes in order to achieve early retirement. Please read my first article on the topic, as this one is a continuation of it.

The problem with my thesis is that $13,125 in a taxable account that yields 3% will generate $393.75 in annual dividend income that’s taxed at 15%. The net income is $334.69 if you collect the dividend income while you are working. If you do not have any taxable income, you would keep the whole $393.75 in dividend income, without paying any taxes. If the $17,500 that is invested in the 401 (k) will earn $525/year at 3%, that income will be tax deferred. However, if you wanted to access this amount before the age of 55 for 401 (k) and before the age of 59.5 if you converted to an IRA, you would pay a 10% early withdrawal penalty in addition to 25% if your taxable income is over $36,250. This translates into $354.37 in net dividend income if you paid taxes while you are working and you are younger than 55 years old. If you have zero taxable income however, you would only end up paying a 10% early withholding penalty, so would you end up with $472.50 in annual income to spend. As you can see, the savings add up really quickly in a tax deferred account. Those savings can result in higher distribution incomes for you to enjoy in your retirement.

Now, if at the time you retire you are over the age of 55 ( for 401K) or 59.5 (for IRA’s) or if you choose to do Substantially Equal Periodic Payments (Check Financial Samurai’s article on those), you can essentially avoid paying the 10% early withdrawal penalty. Therefore, for income under $10,000/year for singles, you would not owe any taxes whatsoever. If your taxable income is less than $36,250 for single individuals or under $72,500 for married individuals, you would pay 15% at current marginal tax rates. Therefore, if you are paying a 25% marginal tax rate today, and you expect to be earning less in your early retirement at say 10% or 15%, it makes perfect sense to use tax-deferred accounts to save. You would essentially be playing tax arbitrage, and be able to accumulate more investable assets to your name. More money on your name could potentially result in more income, when compared to a pure taxable investing only strategy with the same investments in focus.

The problem with my thesis is that 401 (k) plans are not available for all employees. In addition, 401 (k) plans are very restrictive about the types of investments you can make in them. In the case that 401 (k) plans are not available for you, you can put $5,500 in a tax- deductible IRA for singles or married taxpayers whose spouse is also not covered by a retirement plan at work. If you had managed to find a spouse who is covered by a retirement plan at work, you need to be making less than $178,000 in annual income. Otherwise, you cannot get a tax break by contributing in an IRA. With IRA’s you can put less than the amount of 401 (k) plans, but you have the option of investing in any security you want.

With 401 (k) plans, you might be stuck with high fee mutual funds, which could also be doing much worse than your plain vanilla index fund. Depending on the types of investments available in your 401 (k) plan, and the time you plan on holding on to that plan, it might not make sense to use this form of tax-advantaged savings. In most cases however, it might still make sense to do 401 (k) investing, even with a mutual fund where you pay 1% in annual management fees, mostly due to the steep tax savings you are making. It would especially make sense if you plan on rolling that 401 (k) money into an IRA within 5 years or so.

If your plan offers low cost index funds, it might be worth it to stick with them if you have only a few years prior to retirement. After you retire, you can convert this 401 (k) into an IRA, and buy the best dividend paying stocks.

Stay tuned for the third installment of this tax series tomorrow.

Full Disclosure: None

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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
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Eleven Dividend Paying Stocks I Purchased Last Week

Tuesday, October 22, 2013

Why I Considered Tax-Advantaged Accounts for My Dividend Investments

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

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Wednesday, September 18, 2013

Ten Dividend Paying Stocks I purchased in September

Earlier this year, I decided to max out any tax-deferred accounts I am eligible for. This included 401 (k), Sep IRA and ROTH IRA. My goal is to not only have a diversified income portfolio, but to diversify from a tax perspective as well. At the beginning of September, I tweeted about purchasing shares in ten attractively valued companies in my Roth IRA. The Roth IRA has several very appealing features such as tax-free compounding of capital, distributions are never taxed and there are no required minimum contributions.

I allocated $2,000 to the purchase of ten securities in September, and have $3,500 more to invest until the contribution limit of $5,500 for 2013 is exhausted. The brokerage used to execute this transaction was Sharebuilder. I believe that this is the best brokerage to use if you are just starting out your dividend investing journey and have low initial amounts of capital to invest.

It is important to maintain low costs when purchasing dividend paying stocks. As a rule, I try to avoid paying more than 0.50% in commissions on my purchases. With my regular accounts, it is easy to achieve that if I pay less than $5/trade and invest at least $1,000 at a time. With Roth IRA’s however, the $5,500 limit makes it difficult to invest in more than 5 – 6 companies/year at such commission rates. Since I have much more ideas than that, and since I wanted to have a diversified allocation each year, I decided to buy a greater number of companies. I signed up for Sharebuilder’s automatic investment program, which charges $12/month for 12 automatic monthly stock purchases. These stock purchases are executed on Tuesdays, with the automatic investment program. I also wanted to build the allocation over a period of time, rather than in a lump sum. I am allocating $2,000 in September, $2,000 in October and $1,500 in November. Since the first month of signing up was free, I am essentially going to end up spending $24 to invest $5,500, which is only 0.43%. After that I am going to cancel the service, until I am ready to put the contributions for year 2014 to work.

I purchased shares in the following ten companies in early September: (open link in another window)



Full Disclosure: Long all stocks listed in the article

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Monday, April 15, 2013

Six Dividend Paying Stocks I Purchased for my IRA

Readers of my April fools post chuckled at my spending addiction, where I mentioned how the tax man was preventing me from investing in stocks for almost two months. I recently opened an IRA, and allocated the funds equally in the following six dividend stocks:

Chevron Corporation (CVX), through its subsidiaries, engages in petroleum, chemicals, mining, power generation, and energy operations worldwide. The company has raised dividends for 25 years in a row, and has a ten year dividend growth rate of 9.60%/year. Currently, this dividend achiever trades at 9 times earnings at yields 3%. Check my analysis of Chevron.

Philip Morris International Inc. (PM), through its subsidiaries, manufactures and sells cigarettes and other tobacco products. The company has raised dividends for 4 years in a row. Currently, the stock trades at 18.60 times earnings at yields 3.60%. Check my analysis of Philip Morris International.

Johnson & Johnson (JNJ), together with its subsidiaries, engages in the research and development, manufacture, and sale of various products in the health care field worldwide. The company has raised dividends for 50 years in a row, and has a ten year dividend growth rate of 11.70%/year. Currently, this dividend champion trades at 16.90 times earnings at yields 3%. Check my analysis of Johnson & Johnson.

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. The company has raised dividends for 36 years in a row, and has a ten year dividend growth rate of 28.40%/year. Currently, this dividend champion trades at 19.30 times earnings at yields 3%. Check my analysis of McDonald’s .

Kinder Morgan, Inc. (KMI) owns and operates energy transportation and storage assets in the United States and Canada. The company has raised dividends ever since it went public in 2011, yields 3.80% and is projecting to grow them by over 10%/year for the foreseeable future. Check my analysis of Kinder Morgan.

Vodafone Group Plc (VOD) provides mobile telecommunication services worldwide. The company has raised dividends since 1989. Since 2002, the annual dividend in British Pounds has increased from 1.47 pence/share to 9.52 pence/share in 2012.. Currently, this international dividend achiever yields around 5%.

The reason why I purchased these companies is because they were attractively valued at the moment, provided decent entry yields and the opportunity for growth in earnings and dividends going forward.

By making this IRA contribution, I was able to reduce my tax due by more than half. The amount I put in that IRA produced an instant tax savings that was equivalent to over one third of its value in taxes. This also made me review my paychecks closer, and I noticed that I pay in taxes an amount that could easily cover 60% of my expenses. This was the tipping point that made me think about reducing tax expenses, in order to accumulate as much funds in my name, both in taxable and tax-deferred brokerage accounts. Most people do not even realize the amount of taxes they pay each year, because they are automatically withdrawn from their paychecks.

Long-term readers might have sensed the fact that I am a big fan of early retirement. According to my 2013 goals, I discussed how I would be able to retire in five – six years. As a result, I have always discussed that I keep most of my investable assets in taxable brokerage accounts. It made sense for me to only put the bare minimum in tax-deferred accounts such as 401 (k) only to get the company sponsored match. Since 2009, I have consistently ended up owing money to the government come April 15. What I realized over the past year is that the taxes I end up paying do not provide a specific benefit to myself. These taxes help pay for roads, defense, education and public services, but the payment of them was costing me a lot of money. Just looking at my paychecks I recently realized that I need to make a change. As a result, I am going to contribute the maximum I can in 401 (k) plans and IRA’s, in order to reduce my taxable income. Any tax savings from deferring my spending will be directly realizable to moi, although there are a few obstacles to that.

The first issue is that there are limited investment options for 401 (k) plans. For IRA’s however, it is possible to put individual dividend paying stocks. As a portion of my total portfolio however, I do not foresee the sum of 401 (k) and IRA accounts to exceed 15% – 20%. If I choose to retire in five years, I should be able to convert my 401 (k) into an IRA, and invest the money as I see fit. This is not an ideal situation, but any money I put into a 401 (k) would translate into immediate returns of over 1/3 the invested amount, because of tax savings. To me, investing in index funds and not in individual dividend stocks is worth generating a 33% return through the instant tax savings. Most of my current 401 (k) money is in an old 401 (k) from my last employer that I left in the prior year. I plan to roll this into an IRA, which would allow me better flexibility with my investments.

The second issue is that funds in tax-deferred accounts such as 401 (k) and IRA cannot be easily accessed at a whim. There is a 10% early withdrawal penalty on money that is withdrawn prior to ages 55 for 401 (k) and 59 ½ for IRA’s. In addition to that, investors need to pay ordinary tax rates on money that is distributed. Investors in Roth IRA’s can withdraw contributions without any penalties, but they do not get a tax break for contributing today.

So to summarize, I am better off getting tax deduction today that allows me to save an amount each year, which is lost for me when paying taxes. I am much better off to have some claims to money in the future even if accessing it is more difficult, than to simply throw it away (by giving it to the federal and state and local governments). The rate at which I will accumulate individual dividend stocks in taxable brokerage accounts would decline from 3 new purchases a month to 2 purchases every month. An interesting fact is that when I increased my 401 (k) contribution from 6% to 10%, my paycheck decreased only by % .

Throughout my early retirement, I expect that the majority of income will come in the form of dividends, distributions and some 1099 business income. This would put me in a lower tax bracket, which is why distributions from an IRA in early retirement would still be a cheap way to withdraw money if I had to, even with the 10% penalty on distributions. However, if I choose to go to Substantially Equal Periodic Payment arrangement, I might end up withdrawing dividends from that IRA, without having to pay the 10% penalty. I found two calculators behind SEPP here and here. Depending on your age at retirement, the distribution you can take without paying the 10% penalty could cover 50% - 75% of your annual dividend income earned from that particular portfolio, assuming a current yield around 3.50% - 4%.

Full Disclosure: Long CVX, PM, JNJ, MCD, VOD, KMI

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Wednesday, April 25, 2012

Should income investors worry about higher dividend taxes?

I have structured my portfolio in a way, that I receive regular dividend payments every month, quarter or year. My secondary objective is to generate at least market average total returns. As an investor, my goal is to generate solid total returns. I achieve this by selecting companies, which will grow earnings, thus afford to pay higher dividends over time and hopefully will be able to sell at higher market prices in the meantime. I do not worry much about what the tax rates will be in 2013, or over the next four decades. I only worry about selecting great companies.

This might sound like heresy for many investors, who are anxiously hearing about the expiration of the current preferential treatment of dividends in 2012. This could mean that dividends will be taxed as ordinary income, the same way that bonds are taxed today. This could bring a potential 43.60% tax rate on the highest income brackets, if taxes are increased as well.

First, few people are actually making a lot with dividends. Research I have uncovered shows that the average investor in their 60’s does not make more than a few thousand dollars in annual dividend income. For a retired individual, even if dividends are taxed as ordinary income, they would likely not end up paying that much more in taxes. Of course, if you are a highly compensated lawyer or a company executive officer, chances are that you will be paying that high tax rate. Although no one likes paying taxes, there are few options that investors can choose.

One such option is to put all your money in tax-deferred accounts like IRA’s or ROTH IRA’s. Most investors typically have a large portion of their net worth tied up in IRA’s or 401 (k) plans. Unfortunately, 401 (k) plans do not offer investors much flexibility in investment options beyond the traditional mutual funds. Utilizing Roth IRA’s would essentially shield investors from paying any taxes during their accumulation period, as well as during their distribution period, as long as they take earnings out after the age of 59 ½ years. In a previous article however, I discussed that there is a $5000 annual limit in saving for retirement in a tax deferred Roth IRA account. Because of this, serious dividend investors would likely have a small amount of their assets in tax deferred accounts.

Many investors also fear the fact that an increase in dividend tax rates would cause corporations to shift their focus from paying dividends to buying back stock. In my experience as a dividend investor, I would say that the companies that have had long histories of paying and even raising distributions to shareholders will continue to do so. After all, companies like Procter & Gamble (PG) or Coca-Cola (KO) have boosted dividends for over 5 decades, while paying dividends for at least one century. The past five decades have been characterized by top marginal taxes on dividends which have been much higher than the proposed tax increase. In addition, a large portion of the population does have balances in their 401 (k) retirement accounts however. These accounts are mostly invested in mutual funds, who these days own large stakes in America’s largest publicly traded companies. As a result, I do not expect many dividend growth companies to change their payment cultures overnight.

Another reason why investors should not be worried, at least not yet, is the fact that the proposed tax increase in the 2012 budget is not set in stone. The preferential treatment on dividends might still get extended for a few years. Back in 2010, the preferential treatment on dividends was extended for two years. As with most other important decisions, I expect that the outcome related to uncertainties behind dividend tax rates will be resolved in the last minute.

In addition, I do not pay much attention to taxes, because there is always a tradeoff involved. I could put all my money in tax deferred accounts, but I would have to wait until I am in my late 50s before I can withdraw income without paying any penalties. Placing my investments in taxable accounts exposes me to paying taxes on dividend and realized capital gains, but allows me the flexibility to withdraw and spend money as I please. I choose to select the best dividend stocks that will grow earnings, dividends and hopefully stock prices while I hold on to them. It is much easier to rely on dividend payments, rather than to worry about stock prices, in order to sell shares for income in retirement. Dividend payments are much less volatile in comparison with capital gains, and always represent a positive return on investment. Capital gains on the other hand are not income, until they have been realized by selling stock.

Taxes are just one aspect of the investment decision making matrix. In order to make the best decision, investors need to determine whether the company they are evaluating is attractively valued, has long term upside potential, and only after that should they worry about potential bite from dividend taxes. Worrying about taxes on dividend income, is akin to purchasing dividend paying stocks only based on yield. Investors will be much better off just starting their accumulation process in taxable or tax-deferred accounts, rather than waiting until all the uncertainties are over. After all, investing is all about embracing various risks, and having the plan to address or mitigate them through your retirement strategy.

Full Disclosure: Long PG and KO

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Friday, October 28, 2011

Roth IRA’s for Dividend Investors

Nothing is certain in this world except for death and taxes. For many dividend growth investors, this could be characterized as a feeling that they are being taxed to death. While I keep most of my assets in taxable brokerage accounts, I am always on the lookout to legally minimize my investment taxes as much as possible. In fact there is a way to invest in dividend paying stocks without ever having to pay taxes on your investment.

The Roth IRA allows individuals who have earned income in a given year to contribute up to $5000 in after-tax dollars to their retirement account. There is a catch-up contribution of $1000 for individuals who are 50 years of age or older. While contributions to Roth IRA’s are not deductible on your tax returns, earnings and principal distributions are tax free once certain age and time requirements are met. Roth IRA’s allow for tax-free compounding of capital over time.

The earned income includes compensation from salary, wages, commissions, bonuses and alimony. Income from interest, dividends, annuities or pensions does not count as earned income in the eyes of the IRS.

The contribution limit for a Roth IRA is the same as the contribution limit for a regular IRA. However the amount that can be contributed to a Roth IRA is the amount remaining after subtracting any contribution made to a regular IRA. This means that if you contributed the maximum allowable amount to your regular IRA of $5000, you would not be able to contribute anything to a Roth IRA in that year.


There are no required minimum distribution rules for Roth IRAs. However, there are phase-out income limits for high earning taxpayers, which reduce the opportunity to use this tax advantaged investment account.

In order to avoid paying taxes on distributions from Roth IRA accounts, investors need to become acquainted with the qualified nontaxable distribution rules.

According to the IRS, qualified nontaxable distributions for Roth IRA’s are those made at least 5 years after the taxpayer’s first contribution to a Roth IRA and made:

1) After the taxpayer become 59.5 years old
2) To a beneficiary after the death of the taxpayer
3) Because the taxpayer becomes disabled
4) For a use of a first time homebuyer

The biggest benefits of a Roth IRA are the long-term tax free compounding of capital, the fact that qualified distributions are tax-free and the fact that there are no required minimum distributions. Another little known fact behind Roth IRA’s is that direct contributions may be withdrawn at any time. This makes them a perfect investment vehicle for investors who plan on retiring early and living off dividends before they reach typical retirement ages of 60 years.

I hold several stocks in Roth IRA accounts. Given the fact that the limit is $5000/year and that I typically purchase stocks in $1000 increments, I do not own a whole lot of different companies in my ROTH. The five companies I plan to add to my Roth IRA in 2011 include:

Philip Morris International Inc. (PM), through its subsidiaries, manufactures and sells cigarettes and other tobacco products. Yield: 4.30% (analysis)

Johnson & Johnson (JNJ) engages in the research and development, manufacture, and sale of various products in the health care field worldwide. Yield: 3.50% (analysis)

The Procter & Gamble Company (PG) provides consumer packaged goods in the United States and internationally. Yield: 3.40% (analysis)

PepsiCo, Inc. (PEP) engages in the manufacture, marketing, and sale of foods, snacks, and carbonated and non-carbonated beverages worldwide. Yield: 3.20% (analysis)

Kinder Morgan, Inc.(KMI) owns and operates energy infrastructure in the United States and Canada. The company operates in six segments: Products Pipelines-KMP, Natural Gas Pipelines—KMP, CO2—KMP, Terminals—KMP, Kinder Morgan Canada—KMP, and NGPL PipeCo LLC. Yield: 4.60% (analysis)

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- Kinder Morgan Partners – One Company three ways to invest
- Philip Morris International (PM) Dividend Stock Analysis

This article is part of 2012 Roth IRA movement.

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