Thursday, August 6, 2020

Warren Buffett: America's Youngest Early Retiree

In 1954, Warren Buffett got a job at Graham-Newman, which was a value investing company with an impressive track record. The company was managed by Benjamin Graham, the author of Security Analysis and The Intelligent Investor. Benjamin Graham is said to be the father of value investing, and one of the original security analysts to put security analysis on the maps. His annual salary was $12,000.

Buffett had sold securities prior to that, managed his own portfolio and participated in numerous business ventures, including placing pinball machines in barber shops. Between 1950 and 1955, his net worth increased from $9,800 to $127,000.

This was his dream job. Buffett had been rejected by Harvard, and went to school in Columbia, where Ben Graham taught a course on value investing. Buffett wanted to go work for Graham after graduating. He even offered to work for free, but Graham rejected him at the time as “overvalued”.

After selling securities for his father’s firm between 1951 and 1954, Buffett received an offer from Ben Graham, which he accepted on the spot. This was his dream job to work for his mentor.

In 1955, Buffett learned that Ben Graham was going to retire and close his investing company.

Warren declined the opportunity to become a partner in Graham-Newman. Instead, he chose to retire. He shares this story in this great article.

He was 25 at the time, married with a kid. However, he was not worried at all. These are his words, as discussed in a Forbes article from a few years ago:

The thing is, when I got out of college, I had $9,800, but by the end of 1955, I was up to $127,000. I thought, I’ll go back to Omaha, take some college classes, and read a lot—I was going to retire! I figured we could live on $12,000 a year, and off my $127,000 asset base, I could easily make that. I told my wife, “Compound interest guarantees I’m going to get rich.”

Warren Buffett decided to become a private investor in 1955, and live off his capital base. He retired at the age of 25. He expected that his investment skill would be sufficient to generate as much money as his old day job at Graham-Newman.

Retiring early to pursue your passions is a concept that many Financial Independence Retire Early (FIRE) Blogs focus on. Living on your capital, rather than employment is the goal for many of these folks. We do get inspired by folks like Mr Money Mustache who retired at the age of 30 after a decade of investing or Derek Foster, who retired at the age of 34.

Here we have Warren Buffett, who retired at the age of 25 however. He retired to live life on his own terms, and do what made him excited to get out of bed every morning and "tap dance to "work"". Similar to every early retiree, he focused his attention on pursuing his passions and focus on what's important for him in life. And he succeeded beyond his wildest dreams most probably.

To put things in perspective, the average salary for a full-time employee in the 1950s was roughly $5,500/year. So Buffett was earning above average income, and he was expecting to earn an above average income from his investing.

It looks like he expected to generate 10%/year and live off these proceeds. That’s a pretty high annual return needed, but this is the Oracle of Omaha we are talking about. He has been able to compound money at Berkshire Hathaway and the Berkshire Partnerships at 20%/year for decades. Which means that even if he remained a private investor, he would have likely continued to compound his money at more than 10%/year, even after paying for his living expenses.

The most fascinating thought process for me is that if he had managed to compound his capital, net of living and investment expenses, at 10%/year between 1955 and 2019, he would have a net worth of $56.6 million today. That would have been an impressive track record, and he would have been wealthier than most investors today. But it is very likely that we would have never heard about him. It is very likely that if he really retired to do his own thing in the 1950s, there wouldn’t have been several books about him, the annual shareholder meetings, and the fame.

In 1955, it would have been quite easy to construct a portfolio of blue-chip companies that yielded 5%. Security prices had just exceeded their pre-Depression highs from 1929, even as earnings and dividend payments had increased substantially.

His lifestyle does not seem very frugal however. Each dollar in 1955 has the same purchasing power as $9.60 in 2019. In other words, an item that used to cost $1 in 1955 can be purchased at $9.60 today. This means that spending $12,000/year was equivalent to spending $115,200/year today. That’s a pretty nice lifestyle to have in Omaha, Nebraska.

For reference, his net worth was quite impressive for a 25-year-old, since his $127,000 in 1955 is equivalent to having $1.20 million today.

It is fascinating to read his opinion on housing from that time.

In Omaha, I rented a house at 5202 Underwood for $175 a month. I told my wife, “I’d be glad to buy a house, but that’s like a carpenter selling his toolkit.” I didn’t want to use up my capital.

However, three years later he did buy a house for a reported $31,500 in 1958. Although I do not know his networth in 1958, I do know that he became a millionaire in 1960, at the tender age of 30.
The nice thing is that he was able to focus his attention to investing full time. The really nice thing is that he had wealthy relatives and friends, who put up money to start his investment partnership in 1956. Later on, money came pouring in through word of mouth. Several of Graham-Newman’s clients invested with Warren Buffett. You can read more about the Buffett Partnership and read his 1956 - 1969 letters here.

He managed to compound that money at high rates of return, beating his benchmarks in the process. As a result, the assets under management for the Buffett partnership compounded to $100 million by 1969. Warren Buffett was worth $20 million by 1969.

This is when he decided to retire for a second time. This time he retired at the age of 39. By 1970, his sole occupation was being a CEO of Berkshire Hathaway.

If he had really just managed to earn 10%/year off that $20 million by retiring and focusing on charity work for example, Buffett would have been worth roughly $2.3 billion. It would still be very impressive, but nowhere close to being one of the ten richest people in the world. Very few would even bother studying his investment record. Just as few are studying the investment records of other investors on the Forbes list worth less than $10 billion today.

It is fascinating that Buffett retired at the age of 25, and decided to live off investment income. He has been fascinated with the power of compound interest since he read the book “1000 ways to earn $1000” as an impressionable teenager. He knew that even a modest rate of return, compounded over long periods of time could lead to impressive results. For example, a dollar you waste in your 20s, could have grown to $117 in 50 years, provided that you invested it at a 10% annualized total return.

While you may not be alive in 50 years, there is a very high chance that a family member or a charitable cause could be there in 50 years, and benefiting from your foresight.

It is also fascinating to think about opportunity costs. If Buffett had decided to just work an ordinary job, and not focus on investments full time, he would still end up rich but not rich enough to have biographies written about him, and world leaders reaching out to him on the phone in times of crisis. He retired twice, at the ages of 25 and 39. However, he retired to do something better than before.

It is even more fascinating to look at mistakes made, opportunities missed and calculate their impact, decades down the road. Doing so really makes you understand how a simple decision can have a type of butterfly effect that reverberates over the decades.

For example, back in 1951, Buffett lost 20% of his networth on a Sinclair station that he tried to manage. That was approximately $2,000, as he was worth $10,000 at the time. In a 1998 speech he mentioned that the opportunity cost of those $2,000 was something like $6 billion. It is triple that amount now.

I am pretty sure that he would have been wealthier if he had not bought his house in 1958. But at some point, you need to use the money to create the sort of life you need, not be a slave to the power of compounding either.

He made a smart decision at the age of 25 to retire early, and create a life that is true to his values.  The money was merely a scorecard, a byproduct of his passion for investing. Investing is something he did when he was a teenager worth a few hundred dollars and it is something he still does, by managing a corporation worth hundreds of billions of dollars.

"Although I had no idea, age 25 was a turning point. I was changing my life, setting up something that would turn into a fairly good-size partnership called Berkshire Hathaway. I wasn’t scared. I was doing something I liked, and I’m still doing it."

You can see his networth by age in the chart below:

Image for post

Relevant Articles:

Buffett Partnership Letters
The one lesson about Warren Buffett's success that no one wants to hear
What would happen to Berkshire Hathaway after Warren Buffett is gone?
The Pareto Principle In Dividend Investing
Warren Buffett Investing Resource Page
Warren Buffett’s Dividend Stock Strategy

Tuesday, August 4, 2020

BP Cuts Dividends by 50%

British based energy giant BP PLC (BP) cut dividends by 50% to 31.50 cents/share for each American Depository Receipt ( minus any ADR fees). This was the first dividend cut for BP since 2010, when it had a costly oil spill in the Gulf of Mexico.

This is the second oil major to cut dividends, after Royal Dutch Shell (RDS.B) cut dividends at the end of April 2020.

The turbulent global economy, the pandemic, and the low energy prices are the reasons for this move.  This move would provide the company with more flexibility and strengthen its balance sheet. They are expecting to focus excess cashflows to share buybacks, which are easier and less newsworthy to scrap when things go sour. When you are not making enough profit to support a high dividend, that was set when the times were better, cutting it may be a logical step.

As is the case for each dividend cut, I automatically sell after the news is posted.

If a company later reinstates its dividend, and starts raising it again, I may reconsider it. I did this for BP in 2013 and 2014, but I don't think it was a wise move in hindsight. The same strategy was not a smart move for General Electric (GE) either. While I may need a few more data points, so far it looks like buying back after a dividend is reinstated may not be a good strategy. On the other hand, buying Pfizer after it cut dividends in 2009 would have worked very well ( I didn't buy it).

The oil and gas sector is unable to earn its dividends from earnings right now, based on low energy prices. As a result, there are few bargains to be found in the space.

The interesting fact is that when BP suspended dividends in June 2010, the stock fell as low at $26.75/share. The company resumed paying a dividend in March 2011, and it has distributed $21.53/share so far. By February 2011, the stock was selling at $46 - $48/share.

It definitely looks like for cyclical companies, the time to buy may be when things are gloomiest, rather than when they are on top of the world. That being said, you have to have a good timing twice- first to buy low and second to sell high. I am not good at timing the market, and I doubt many of you are either. Hence, it makes sense to invest in companies that do ok throughout the ups and downs of the economic cycle. This means that exposure to commodity companies may have to be kept low.

Exxon Mobil (XOM) is probably at a high risk to cut dividends over the foreseeable future, because it has been unable to cover the current distribution out of earnings per share. This is from their latest conference call:

Finally, we have a long history of providing a reliable and growing dividend. A large portion of our shareholder base has come to view that dividend as a source of stability in their income, and we take that very seriously. While we manage our capital allocation priorities over the long term, we also recognize the need to balance in the near term to respond to market conditions. In response to the unprecedented environment that we find ourselves in, we've taken decisive action in 2020.

To recap what we've done so far this year. We've reduced short-term capital spending by more than 30%. We're on pace to reduce cash operating expenses by more than 15%. We've increased debt to a level we feel as appropriate to provide liquidity, given market uncertainties, and we will hold it at that level. And we're continuing to pay a reliable dividend.

While it sounds reassuring, this is usually how management teams try to cheer shareholders up, before a dividend is cut.

To me it is fascinating that the oil crash began in 2014. Yet, we didn't really get the oil and gas majors to cut dividends until it intensified in 2020. Energy investors have lived through a brutal 6 year period of negative returns, which is in stark contrast with the situation in 2014, when energy was touted as the next big thing, valuations looked cheap, and energy was one of the best performing sectors over the preceding decade.

Relevant Articles:

Is BP’s dividend safe?
Dividend Growth: The Risk of Being Cocky
Royal Dutch Shell Cuts Dividends For The First Time Since World War II
Are Energy Stock Values Today a Once in a Lifetime Opportunity?

Monday, August 3, 2020

Nine Dividend Paying Companies Raising Dividends Last Week

As part of my monitoring process, I review the list of dividend increases every week. This exercise helps me to monitor existing portfolio holdings, and to identify promising companies for further research.

I tend to focus my attention on companies with at least ten years of annual dividend increases. This activity helps me to focus on companies with a higher chance of delivering sustainable dividends, and lets me identify the companies with a long runway for future dividend increases.

I review each company, in order to determine if it can continue raising its dividends for the foreseeable future. I believe that rising earnings per share are the fuel behind future dividend increases.

I look at rising earnings per share, in conjunction with trends in the dividend payout ratio. A high payout ratio is generally a warning sign, unless the business model is highly predictable or earnings are growing faster than dividends. I generally prefer if earnings and dividends grow at roughly the same long-term rate. Sometimes there are changes, and reasons for why that’s not the case, especially if a company just recently started growing dividends from a low base.

I like to review trends in dividend growth too, and check if it is accelerating, decelerating or just keeping pace at a constant rate.

I also like to review the valuation in terms of P/E and yield. While these are viewed as old-fashioned today, I have found them to be useful yardsticks to follow, along with dividend growth, payout ratio and earnings growth. Valuation is part art, part science.

American States Water Company (AWR) provides water and electric services to residential, industrial, and other customers in the United States. It operates through three segments: Water, Electric, and Contracted Services.

The company raised its quarterly dividend by 9.80% to 33.50 cents/share. This marked the 66th consecutive year of annual dividend increases for this dividend king. During the past decade, this dividend king has managed to grow distributions at an annualized rate of 8.70%.

Between 2009 and 2019, the company grew earnings from 81 cents/share to $2.28/share.
The company is expected to earn $2.29/share in 2020.

The stock is overvalued at 33.60 times forward earnings. The stock yields 1.75%.

Community Trust Bancorp, Inc. (CTBI) operates as the bank holding company for Community Trust Bank, Inc. that provides commercial and personal banking services to small and mid-sized communities.

The company raised its quarterly dividend by 1.30% to 38.50 cents/share. This marked the 40th consecutive year of annual dividend increases for this dividend champion. During the past decade, this dividend champion has managed to grow distributions at an annualized rate of 3.10%.

Between 2009 and 2019, the bank grew earnings from $1.50/share to $3.64/share. The company is expected to earn $3.10/share in 2020.

The stock is attractively valued at 9.90 times forward earnings and yields 5%.

McKesson Corporation (MCK) provides pharmaceuticals and medical supplies in the United States and internationally. It operates through four segments: U.S. Pharmaceutical, Prescription Technology Solutions, International, and Medical-Surgical Solutions.

The company raised its quarterly dividend by 2.45% to 42 cents/share. This marked the 13th consecutive year of annual dividend increases for this dividend achiever. During the past decade, this dividend achiever has managed to grow distributions at an annualized rate of 12.65%.
The company has managed to grow earnings from $2.95/share in 2009 to $4.95/share in 2019. The company is expected to earn $14.40/share in 2020.

McKesson sells for 10.40 times forward earnings. The stock yields 1.10%.

Portland General Electric Company (POR) is an integrated electric utility company, engages in the generation, wholesale purchase, transmission, distribution, and retail sale of electricity in the state of Oregon. The company operates seven thermal plants; seven hydroelectric plants; and two wind farms.

The company raised its quarterly dividend by 5.85% to 40.75 cents/share. This marked the 15th consecutive year of annual dividend increases for this dividend achiever. During the past decade, this dividend achiever has managed to grow distributions at an annualized rate of 4.10%.

This utility managed to grow earnings from $1.31/share in 2009 to $2.39/share in 2019.
The company is expected to earn $2.39/share in 2020.

The company sells for 18.50 times forward earnings. The stock offers a dividend yield of 3.70%.

Republic Services, Inc. (RSG) provides non-hazardous solid waste collection, transfer, disposal, recycling, and environmental services in the United States.

The company raised its quarterly dividend by 4.95% to 42.50 cents/share. This marked the 18th consecutive year of annual dividend increases for this dividend achiever. During the past decade, this dividend achiever has managed to grow distributions at an annualized rate of 7.25%.

Republic Services managed to grow earnings from $1.30/share in 2009 to $3.33/share in 2019.
The company is expected to earn $2.85/share in 2020.

The stock is not cheap at 30.60 times forward earnings. Republic Services yields 1.95%.

The Scotts Miracle-Gro Company (SMG) manufactures, markets, and sells consumer lawn and garden products in the United States and internationally. The company operates through three segments: U.S. Consumer, Hawthorne, and Other.

The company raised its quarterly dividend by 6.90% to 62 cents/share. This marked the 11th consecutive year of annual dividend increases for this dividend achiever. During the past decade, this dividend achiever has managed to grow distributions at an annualized rate of 16.30%.

The company managed to grow earnings from $2.32/share in 2009 to $8.18/share in 2019.
The company is expected to earn $6.37/share in 2020.

The stock sells for 24.90 times forward earnings. The stock offers a dividend yield of 1.55%.

W.W. Grainger, Inc. (GWW) distributes maintenance, repair, and operating (MRO) products and services in the United States, Canada, and internationally.

The company raised its quarterly dividend by 6.25% to $1.53/share. This marked the 49th consecutive year of annual dividend increases for this dividend champion. During the past decade, this dividend achiever has managed to grow distributions at an annualized rate of 12.30%.

Between 2009 and 2019, W.W. Grainger managed to increase earnings from $5.62/share to $15.32/share. The company is expected to earn $15.94/share in 2020.

The stock sells for 21.40 times forward earnings and yields 1.80%.

Altria Group, Inc. (MO) manufactures and sells cigarettes, smokeless products, and wine in the United States.

The company raised its quarterly dividend by 2.40% to 86 cents/share. This marked the 51st consecutive year of annual dividend increases for this dividend king. During the past decade, this dividend king has managed to grow distributions at an annualized rate of 9.70%.

Altria earned $1.87/share in 2010 and is expected to earn $4.31/share in 2020.

The stock is cheap at 9.50 times forward earnings. The stock yields 8.35%.

Eagle Bancorp Montana, Inc. (EBMT) operates as the bank holding company for Opportunity Bank of Montana that provides various retail banking products and services to small businesses and individuals in Montana.

The company raised its quarterly dividend by 2.60% to 9.75 cents/share. This marked the 21st consecutive year of annual dividend increases for this dividend achiever. During the past decade, this dividend achiever has managed to grow distributions at an annualized rate of 3.30%.

The bank grew earnings from 52 cents/share in 2009 to $1.69/share in 2019. The company is expected to earn $2.36/share in 2020

The stock sells for 6.55 times forward earnings and yields 2.50%.

Relevant Articles:

- My Favorite Exercise As A Dividend Growth Investor
Three Dividend Stocks in the News
Two Sweet Dividend Increases For Long-Term Shareholders
Dividends are a fact, share prices are an opinion

Thursday, July 30, 2020

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

Monday, July 27, 2020

Two Sweet Dividend Increases For Long-Term Shareholders

I review dividend increases as part of my monitoring process. This helps me monitor existing holdings, and uncover companies for future research.

In general, I look for companies that have at least a ten year history of annual dividend increases under their belts. I do sometimes look at companies with shorter track records, but I have to really like the business model. I also rarely have a "full position" in companies with shorter track records.

For the purposes of this review this week, I focused on the two companies which declared a dividend increase last week. A third company, Carlisle (CSL) announced their intention to increase dividends for the 44th year in a row in September. However, they didn't specify the amount of dividend increase, which is why I am not going to review them in detail today. I may in September, if they follow through on their word.

The two sweet dividend increases over the past week include:

The Hershey Company (HSY) manufactures and sells confectionery products. The company operates through two segments, North America; and International and Other.

Hershey delivered a sweeet dividend increase of 4% to 80.40 cents/share. This marked the 11th year of consecutive annual dividend increases for this dividend achiever.

Over the past decade, Hershey has managed to increase dividends at an annualized rate of 9.65%.

Hershey has managed to grow earnings from $2.21/share in 2010 to $5.46/share in 2019.

The company is expected to generate $5.86/share in 2020.

The stock is overvalued at 24.85 times forward earnings. Hershey yields 2.20%.

The J. M. Smucker Company (SJM) manufactures and markets food and beverage products worldwide. It operates in four segments: U.S. Retail Pet Foods, U.S. Retail Coffee, U.S. Retail Consumer Foods, and International and Away From Home.

J.M. Smucker raised its quarterly dividend by 2.30% to 90 cents/share. This marked the 23rd year of consecutive annual dividend increases for this dividend achiever.

Over the past decade, J.M Smucker has managed to increase dividends at an annualized rate of 9.70%.

Between 2010 and 2020, J.M. Smucker managed to grow earnings from $4.15/share to $6.84/share.

The company is expected to earn $6.53/share - $6.93/share in 2021.

The stock seems attractively valued at 16.60 times forward earnings. J.M. Smucker yields 3.30%.

Relevant Articles:

Five Dividend Growth Stocks Rewarding Shareholders With Raises
Two Cheap Dividend Stocks Raising Dividends Last Week
My Favorite Exercise As A Dividend Growth Investor
Let dividends do the heavy lifting for your retirement

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