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

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. After age of 65, withdrawals are tax-free for any type of distribution from the account. Withdrawals not for qualified medical expenses are subject to a 20% penalty and income tax.

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.

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. 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 send 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 realize 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), you 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,

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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

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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

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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.

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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

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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

Relevant Articles:

Why I Considered Tax-Advantaged Accounts for My Dividend Investments
Is Dividend Mantra Wrong on Taxes?
Roth IRA’s for Dividend Investors
Six Dividend Paying Stocks I Purchased for my IRA

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