Taxable versus Tax-Deferred Accounts for Dividend Investing

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

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

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

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 Direct contributions can be withdrawn tax-free at any time, although investors need to wait until they are 59 ½ years old, before they can withdraw gains from the account without a penalty.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

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

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

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

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

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

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

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

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

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

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

How is that possible?

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

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

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

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

Full Disclosure: None

Relevant Articles:

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

What if taxes increase?

When I invest in a taxable account, I have to pay taxes on any ordinary and qualified dividends I receive over the course of an year. While I am a buy and hold investor, I also have the occasional capital gain or loss. Naturally, I expect to receive a net capital gain when companies get acquired or perhaps a smaller gain when they cut dividends.

Taxes reduce the amount I can re-invest back into my portfolio. I view these investment taxes as waste in the accumulation process.

I made the capital for my investments through labor. I pay taxes on the income I generate through employment, which further reduces the amounts I can invest every month.

As part of my investment plan, I try to prioritize investing through tax-deferred accounts first, before adding to taxable accounts.

I do this in order to minimize the tax bite on dividends and capital gains in the accumulation phase, which can amount to a substantial amount. I also do this in an effort to reduce the amount of taxes I pay upfront, and compound my dividend income and capital without tax waste for decades down the road.

When I reduce the amount of taxes I pay today, I have more money to invest. I achieve that due to the tax breaks I have up-front from some accounts such as regular 401 (k), H SA and SEP IRA. I also have more money to invest, since a larger portion of my investment income is now in tax-sheltered accounts. For regular IRA/401 (k) accounts tax may either be due at some point in 30 – 40 years. For others like my Roth IRA/Roth 401(k), I will never have to pay tax on the distributions.
You can read a brief overview of each account in this article. You may also find it helpful to read about ways to withdraw from retirement accounts prior to the age of 59 1/2.

I have discussed previously how utilizing tax-deferred accounts correctly can result in higher dividend incomes for the same levels of effort. This simple change can shorten your financial independence journey by shaving off years of extra effort toiling away at a thankless job for no other benefit than to pay more taxes. If you enjoy working, tax advantaged accounts help shelter a ton in taxes in the accumulation process, when you are in a higher tax bracket than when you retire.

I view investing through tax-deferred accounts as a natural hedge against rising rates on income.
When you are investing in a taxable account, you have to pay the going tax rate on dividends and capital gains. You will likely have to pay money every single year. Under the current administration it is possible to avoid paying taxes if you earn $100,000 in qualified dividend income and have no other income source. However, it would take you many years of paying a lot in taxes on income and investments before reaching this goal. Naturally, you will be having less dollars working for you, since you will be paying the tax man every year.

If you invest through a tax-deferred account, you get to defer paying taxes on dividends and capital gains. Roth IRA’s are funded with after-tax dollars, but you will not have to pay taxes on withdrawals. This means that you paid your Federal and State taxes first, and then used that after-tax money to start your Roth IRA. This concept is the same for Roth IRA, Roth 401 (K) accounts as well, even if their contribution limits vary. Typically, you can withdraw contributions after 5 years, but you can only withdraw gains penalty-free after the age of 59 ½. There are required minimum distributions for Roth 401 (k) accounts at the age of 72, but not for Roth IRA accounts. Withdrawals are not taxable. In order to avoid required minimum distributions on Roth 401 (k) accounts, an investor can simply rollover that Roth 401 (k) into a Roth IRA. There may be other considerations involved, like asset protection, so it may make sense to speak to a tax professional first.

Regular IRA’s are funded with before-tax dollars, meaning that you get to avoid paying a tax at the Federal and State level when you contribute to these accounts. The concept is the same for Regular/SEP IRA’s, Regular 401 (k)/457b/403(a) plans, even if the contribution limits for each account varies. As a result of this tax hack, you get more money to invest today, since you are reducing your taxable amount due to your retirement plan contribution. When you withdraw principal and earnings from the account, they are all taxable at your ordinary income tax rate. It is not a problem for most folks however, since people tend to be at higher tax brackets when they work, and in lower tax brackets when they retire.

Other benefits of before-tax accounts include reducing your taxable income, which may potentially qualify you for different credits or benefits such as ACA credits. If maxing out your 401 (k) put you in a lower taxable income, and you became eligible for the 2020 economic relief payments, that was an ROI that was unexpected, but still a plus for maxing out your retirement contributions.

The government does want you to start taking money out of these retirement accounts by the time you are 72, because they want you to start paying taxes and not just defer paying forever. There are ways to avoid taking distributions however. My popular one is that if you are still working at a company that you own no more than 5% in, your 401 (k) at this company does not need to start required minimum distributions. I am sure that there are other loopholes to defer distributions from an IRA or 401 (k), but you would likely have to hire an expensive CPA for it.

The nice thing about retirement accounts is that you get to defer or avoid paying taxes in the crucial accumulation phase. This may also simplify your life if you actively manage your investments too.
As I mentioned above, when people work, they are usually in a higher tax bracket than when they retire.

As a result, putting money in regular IRA/401 (k) accounts is better than using the Roth option, due to this tax arbitrage nature of things. The risk you face with regular accounts is that the tax rates will be much higher when you withdraw the money, even if you are in a lower tax bracket.

With Roth accounts, you are essentially locking in the money at your going tax rate. If you end up moving up in your career, you would likely be better off starting with a Roth and then evaluating if a Regular IRA is better for you. The risk you take with Roth IRA’s is that tax rates would go lower by the time you retire, which means that you would have ended up with less money than ideal.
I believe that contributing to Roth IRA’s or Roth 401 (k) is best if you are a in lower tax bracket today, and effectively want to lock that rate in. Another reason for contributing to a Roth over a Regular account is if you cannot contribute to a regular IRA.

I recently shared my ideas with investors, and received some interesting pushback. It looked like some investors prefer taxable accounts to retirement accounts, because they are afraid that tax rates in 20 – 30 – 40 years will be much higher than they are today.

Naturally, no one knows where tax rates will be in the next 30 – 40 years. However, we do know that in general, most folks will be in lower tax brackets in retirement, in comparison to the tax brackets they had when they were working. It is all a moving target of course, since the lowest tax rate in 40 years may turn out to be higher than the highest tax bracket we have today. It could also be that the highest tax rate in 40 years will be about the same as the lowest rate we have today.

I decided to run some scenario analyses, in order to compare and contrast different outcomes. You can download this spreadsheet that includes the calculations behind each scenario.

The first scenario looks at an investor who is in the 22% Federal Tax Bracket today, and is in the 5% State Tax Bracket. The tax on qualified dividends is 15%, and they also owe their friendly state another 5% on dividends. We are going to assume that this investor will generate a total return of 7%/year –5% for capital gains and 2% for dividends. Our investor will save $1,000 in 2020, and have the option of doing a regular taxable account or a regular IRA account. We would assume that our investor would be withdrawing ALL the money in 2060 at the prevailing tax rates. My assumptions are that Federal tax rates in 2060 will be at 40%, the state tax rates will be at 5%, and qualified dividends will be taxed at 15% at the Federal and 5% at the State Level. This is an unfair comparison to tax-deferred accounts, because it assumes that the tax rates on ordinary income double, while taxes on investment income stay flat. We are also deferring at a pretty reasonable tax rate today, but that rate is average. The numbers would look differently for a highly paid physician, lawyer or executive.
It looks like in 2060, the taxable account ends up being worth 12,891.05. After selling all stock, and paying taxes on gains (15% + 5% = 20%), we are left with 10,512.84.

The IRA account is worth 20,512.96 by 2060. If we withdraw the money at once, we pay 40% to the Federal Government and 5% to the state government, and we are left with 11,282.13. The Federal Tax rate would have had to increase to 43.50% for the after-tax return on traditional IRA to be on par with the taxable account.

The reason for the difference is because the taxable account pays taxes on dividends each year, which results in a net return of 6.60%/year, versus 7%/year for the tax-deferred account. This difference would have been more pronounced if dividend yields were higher than 2% too. In addition, by contributing to an IRA in the accumulation phase, we save $369.86 on taxes, which are then plowed back into that IRA.

I had to double check the amount saved on taxes and make sure it makes sense. If we have hit the limits on how much we can put in a tax-deductible IRA, the savings are simply the tax rate times the amount contributed. So the amount saved would be $270 invested in a taxable account.
Because the IRA limits are much higher than $1,000/year, we have at least $5,000 in extra room to contribute. And if you view the traditional 401 (k) as a form of traditional IRA, we have an additional $19,000 to contribute to.

When you receive a tax deduction to contribute to an IRA, and you have extra room left to contribute, you can compound those tax advantages in a way.

That’s because if we just contributed an extra $270 to the IRA from the savings on the $1,000 contribution, we would also generate tax savings on the $270. That’s 72.90 in savings on the $270 extra that we were able to contribute to the IRA, because of tax savings in the first place.
That 72.90 in additional tax savings open up room for 19.68 in additional tax savings… And so on, until we are left with a total savings of $369.86 merely because we contributed to an IRA that is tax-deductible.

Either way, the upfront tax savings, and the deferral of investment gains for 40 years definitely help the traditional IRA investor over the taxable one.

If we had simply placed the money in a Roth IRA however, we would have not generated any upfront tax savings. However, we would have compounded the money at 7% per year, and we would have $14,974.46. Since there are no taxes on withdrawals, we have 14,974.46 to withdraw.

It looks like under this scenario, the Roth IRA beats the traditional IRA and the taxable account on an after-tax return basis. On a gross return basis in 2060, the IRA beats the Roth and taxable accounts.
The increase in taxes definitely makes the traditional IRA a worse option than the Roth in this scenario.

If you could pay less than 27% in taxes on the Traditional IRA distributions, you would have done better than the Roth. That would require forecasting future tax rates, but also knowing the intricacies of the tax code. If it comes down to moving from a state with income tax to a state with no income tax, this may be worth it. Again, a good CPA may be able to find a way to help you keep a larger portion of your wealth. And they may be able to help in planning along the way.

In a real-time scenario however it may be possible to withdraw money strategically, by increasing distributions before taxes rise and reducing them when they are higher. But tackling every individual scenario is beyond the scope of this blog post. You should feel inspired or bored out of your mind so that you think about your tax planning situation, and perhaps even hire a friendly CPA/tax accountant to help you plan ahead and devise a plan to minimize taxes and maximize wealth.

If you could pay less than 27% in taxes on the Traditional IRA distributions, you would have done better than the Roth. That would require forecasting future tax rates, but also knowing the intricacies of the tax code. If it comes down to moving from a state with income tax to a state with no income tax, this may be worth it. Again, a good CPA may be able to find a way to help you keep a larger portion of your wealth from the hands of the tax man.

The second scenario will look at the same inputs as the first one. The difference will be that taxes on dividends will rise to 20% at the Federal Level in 2021 but stay at 5% at the State Level. Taxes on Federal Level will be at 40% and at State Level 5% in 2060. The return assumptions are the same.
It looks like in 2060, the taxable account ends up being worth $12,416.07. After selling all stock, and paying taxes on gains (15% + 5% = 20%), we are left with 9,562.06. We end up compounding money at 6.50%/year, due to higher taxes on dividend income in the accumulation phase.

The IRA account is worth 20,512.96 by 2060. If we withdraw the money at once, we pay 40% to the Federal Government and 5% to the state government, and we are left with 11,282.13. The Federal Tax rate would have had to increase to 48.50% for the after-tax return on traditional IRA to be on par with the taxable account.

The Roth IRA ends up with $14,974.46 to withdraw tax free. It is a clear winner, unless you managed to find a way to obtain the distributions from a Traditional IRA while paying less in taxes. If you could pay less than 27% in taxes on the Traditional IRA distributions, you would have done better than the Roth. That would require forecasting future tax rates, but also knowing the intricacies of the tax code. If it comes down to moving from a state with income tax to a state with no income tax, this may be worth it. Again, a good CPA may be able to find a way to help you keep a larger portion of your wealth.

The third scenario looks at a situation where tax rates are unchanged for 40 years. This means that we get to withdraw the money at the same rates used when we put money in.

It looks like in 2060, the taxable account ends up being worth 12,891.05. After selling all stock, and paying taxes on gains ( 15% + 5% = 20%), we are left with 10,512.84.

The IRA account is worth 20,512.96 by 2060. If we withdraw the money at once, we pay 22% to the Federal Government and 5% to the state government, and we are left with 14,974.46. The after-tax return on the traditional IRA matches that of the Roth IRA in this example.

The fourth scenario looks at a situation where tax rates are lower in 40 years. The rates at which we would be contributing stay the same ( 22% Federal, 5% state, 15% dividends), but the rates at which we withdraw money will be reduced ( 12% Federal, 0% state, 0% dividends).

At this level, the rates of return for taxable and Roth and Regular IRA are at 7%/year. We end up at the same level of worth for the taxable and Roth IRA’s - $14,974.46.

For the Traditional IRA, we end up with 20,512.96 pre-tax. After we withdraw the funds, and pay the 12% tax rate, we are left with $18,051.40.

After reading through these examples, it may seem to you that I am a little biased towards the traditional IRA/ 401 (k). It is likely the case, or perhaps it is wishful thinking on my part that building a higher net worth in a traditional IRA is better from a pure numbers perspective, because it gives you a higher base to work with. It is easier in relative terms to have $1 million in an IRA, and have to worry about paying $200K - $400k in taxes on it, than to have $600K in a taxable account. You will likely find a solution on how to minimize the tax bite on the traditional, and find ways to tap the money in a tax-efficient way too.

In my personal situation, my assets are diversified across traditional 401K and IRA and Roth IRA /Roth 401 (k) accounts. I also have a taxable account. Since there are limitation on how much I can contribute, I maximize everything I am eligible for today. I see various scenarios playing out, so I will do differently under each. My withdrawals will be optimized to the situation at the time of withdrawals.

I try to maximize the traditional 401 (k) and IRA’s first, because I believe that I will be in a lower tax bracket than today when I withdraw these funds. This may be because my income is lower, because taxes are lower or because I may have also moved to a state that doesn’t tax income. Or perhaps a combination of all of the above. I would put H S A in this category as well. I am not going to calculate the effect of using H S A versus other accounts, because it affects social security contributions and income. I am not an actuary so I won’t go there today. You have already been bored sufficiently on this tax tirade.

I then try to max out any Roth amounts. If there is anything left over, I place it in a taxable account.
I would prefer tax-deferred compounding to compounding in taxable accounts.

My goal is to keep building, because I enjoy building my portfolios. I will probably defer withdrawing funds for as long as possible and just live off any active income I generate in the process (and trying to save and invest any remaining amounts too).

Right now, I won’t have to withdraw until the age of 72. I will consider converting regular 401 (k) dollars into Roth 401 (k) or Roth IRA if I ever find myself in the lowest tax brackets along the way.

As you can see, there are various scenarios when it comes to tax-deferred accounts. And we are assuming a typical 40 year career. Imagine how much more complicated the situation gets if we were looking for an early retirement, where we have to withdraw money in our 30s or 40s.

I actually discussed that in a way in a previous post. But the short summary is that you can withdraw Roth IRA/Roth 401 (k) contributions after 5 years. You can withdraw earnings after the age of 59 ½ without penalty.

For Regular IRA/401 (k) plans, the withdrawal options are very different. If you convert a 401 (k) into a Roth, you will pay taxes on the proceeds, but then you can withdraw that money in 5 years tax free. This makes sense if your rate in retirement is lower than the rate at which you were accumulating capital. You also have the 72 t option, which is the Substantially Equal Periodic Payments option, which allows you to withdraw money from retirement accounts according to a longevity formula. You have to do it every year. Finally, for 401 (k) accounts, you can start withdrawals from the 401 (k) account at the company you worked at, if you leave at or after the age of 55.

Today, we looked at a few different scenarios for contributing money to taxable and tax-deferred accounts. We also looked at how those scenarios play out when we change our assumptions just a little bit. I encourage you all to play around with the spreadsheet assumptions, and test various outcomes. I would also encourage all of you to think more about tax planning.

We also revisited various retirement account types in brief, and also discussed ways to withdraw from them early.

We should remember that life is not linear, and we will have occasional bumps on the road. These may be blessings in disguise. For example, a person who is laid off a couple of years before they plan to retire may be able to convert old IRA's into Roth by paying a minimum amount in taxes. Alternatively, a younger person may also be able to Rothify their 401 (k) accounts if they take an year off for graduate school for example, after a few years of working.

There are avarious possiblities and outcomes to think through. This is why I believe that it is important as investors to think through various scenarios, and learn at least a basic understanding of the tax code. That may pay real dividends down the road.

That being said, if you are afraid of taxes rising in the future, hedging that bet by maxing out retirement accounts may be a good start. Investing in a taxable account is an inefficient way to build wealth, particularly in the accumulation phase for dividend investors.

Thank you for reading!

Relevant Articles:

- Taxable versus Tax-Deferred Accounts for Dividend Investing
- How to buy dividend paying stocks at a 25% discount
- How early retirees can withdraw money from tax-deferred accounts such as 401 (k), IRA & HSA
- How to Grow Dividend Income Much Faster With Tax Advantaged Accounts

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.

Addendum: My retirement strategy for tax-free income explained more thoroughly

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

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

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

How is that possible?

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

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

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

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

Full Disclosure: None

Relevant Articles:

- 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

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

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

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

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

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

Relevant Articles:

- Benchmarking Dividend income
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Should taxes guide your investment decisions?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Full Disclosure: Long KMR, UL,

Relevant Articles:

- My Retirement Strategy for Tax-Free Income
- Dividends Provide a Tax-Efficient Form of Income
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- Six Dividend Paying Stocks I Purchased for my IRA

Performance of Dividend Payers versus Non Dividend Payers in S&P 500

I recently obtained the data behind the performance behind dividend and non dividend payers in the S&P 500 per year. This is a calculation performed by the index committee that separates members of S&P 500 into dividend paying and non dividend paying, and then equally weighting those portfolios. The performance of an equal weighted portfolio of dividend stocks is compared to the performance of an equal weighted portfolio of non dividend paying stocks.

Source: S&P/Dow Jones Data

The number of dividend paying stocks has varied over time. Currently, there seem to be 419 companies paying a dividends, out of 505 members of the S&P 500 index ( the difference is due to the inclusion of multiple share classes on the same company – e.g. GOOG and GOOGL)
Most companies paying a dividend are in mature industries. Most dividend stocks tend to be value stocks, which tend to decline by less during bear markets but still provide sufficient upside during bull markets.

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: Initially I though I was unable to perform this feature, since my HR department doesn't allow for In-Roth Conversions on after-tax accounts. After talking to several people however, I realized they DO allow it.

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

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Look abroad for higher dividend yields

US stocks these days are offering much lower yields than the rest of the world. For example, S&P 500 yields less than 2%, while UK stock indices are yielding more than that. Given the fact that foreign companies are paying more generous dividends that US ones, should dividend investors venture abroad?

Before investors decide to invest in foreign stocks, they need to understand the risks and peculiar characteristics of foreign dividend paying stocks.

In general, most foreign dividend paying companies pay fluctuating dividends each year. Foreign companies are quick to cut dividends if earnings fall even by a small amount, since they target a particular dividend payout ratio, rather than a particular level of dividend payments. US investors who are used to the stability of dividend payments that most American firms exhibit might be disappointed by this feature. Fluctuating dividends make it particularly difficult to live off your investments, and as a result it is best that these companies are avoided.

Adding to the injury, most foreign companies tend to distribute cash to shareholders once or twice per year at best. Many multinationals such as Nestle (NSRGY) for example pay distributions once per year. As a result, investors who like to reinvest dividends have only one instance/year to compound their profits. As a dividend investor, I have found that having the ability to reinvest the same annual dividend in four quarterly installments allows for faster compounding than having the dividend compound just once per year. For the companies that pay dividends twice annually, they tend to split distributions into interim and final payments. The interim payments typically represent 40% of the total annual dividend, while the final payment represents 60% of the total annual dividend. As a result, many US services such as Yahoo!Finance, routinely miscalculate the dividend yields of companies such as UK based company Diageo (DEO), or Vodafone (VOD).

Another factor to consider before purchasing foreign shares is taxes. Many countries such as Canada, France, Switzerland and Netherlands, to name a few, impose taxes on dividends paid out to US investors. These taxes are typically around 15% for Canadian stocks held by US investors for example. While US investors can claim a credit for any taxes withheld at a foreign source in taxable accounts, they cannot do that in tax-deffered ones such as ROTH IRA’s. In addition, some foreign companies such as Unilever have dual class shares with similar rights that trade both in London and Amsterdam. Purchasing the Netherland based ADRs for Unilever N.V. (UN) could lead to tax withholdings, whereas purchasing the United Kingdom based ADR’s for Unilever PLC (UL) could pose no such problems. US dividend taxes would still be due of course, but there is less paperwork trying to claim foreign taxes withheld on dividends.

Another factor to consider includes transaction costs. Many US investors tend to purchase American Depositary Receipts (ADRs) on foreign listed shares. As a result, they end up paying US capital gains taxes and US commissions. If you dare to venture abroad however, you would have to deal with finding the right broker, paying taxes abroad and paying commissions which are probably much higher than the ones in USA.

In general, many foreign companies also report results under IFRS, which is a different accounting standard than the US GAAP. Other factors to consider include the fact that many foreign companies listed in the US are typically global businesses, and therefore would trade similarly with their US competitors. In other words, during the financial crisis of 2007 – 2009, many stocks lost almost half of their values. As a result, venturing out abroad might not have delivered the diversification benefits that international investing is supposed to deliver. However, by expanding the time-frame to look at performance of foreign shares before and after the crisis, one could note a few differences. Because of the global nature of business these days, I avoid international over diversification by purchasing shares of US based multinationals.

There are a few lists with dividend growth stocks, which could aid investors in their search for dividend paying companies with dependable and rising distributions. These include the international dividend achievers index, which lists companies traded in US, which have boosted distributions for at least 5 years in a row. Another interesting benchmark is the Europe Dividend Aristocrats index, which lists European companies which have raised distributions for over 10 years in a row.

Some foreign companies that fit in this criteria include:

Diageo (DEO), which produces, distills, brews, bottles, packages, and distributes spirits, beer, wine, and ready to drink beverages. The company has managed to increase dividends for at least 15 years in a row. Currently, the stock is selling for 19.70 times forward earnings and yields 2.70%. Check my analysis of Diageo.

Nestle (NSRGY), which provides nutrition, health, and wellness products worldwide. The company has managed to increase dividends for 18 years in a row. Currently, the stock is selling for 18.60 times forward earnings and yields 3.10%. Check my analysis of Nestle.

Novartis (NVS), which is a multinational company specializing in the research, development, manufacturing and marketing of a range of healthcare products led by pharmaceuticals. The company has managed to increase dividends for 17 years in a row. Currently, the stock is selling for 17.50 times forward earnings and yields 3%. Check my analysis of Novartis.

Unilever (UL), which is a consumer goods company operating in Asia, Africa, the Middle East, Turkey, Russia, Ukraine, Belarus, Europe, and the Americas. The company has managed to increase dividends for at least 19 years in a row. Currently, the stock is selling for 20.20 times forward earnings and yields 3.50%. Check my analysis of Unilever.

BHP Billiton (BBL), which operates as a diversified natural resources company worldwide. The company has managed to increase dividends 15 years in a row. Currently, the stock is selling for 16.80 times forward earnings and yields 3.50%. Check my analysis of BHP Billiton.

Those companies are a little pricey today, but are good long-term holdings for long-term investors. If prices decrease from here, it would be nice to have those company on a watchlist.

Full Disclosure: Long NSRGY, UL, VOD and DEO

Relevant Articles:

- International Over Diversification
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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:

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- My Retirement Strategy for Tax-Free Income
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