Tuesday, July 9, 2013

How to accumulate your nest egg

On my website, I often talk about investments, but very rarely do I discuss the process to accumulate anest egg. I often assumed that investors who read my site are there because they have the cash. However, some feedback in my previous article, where I outlined the benefits of dividend investing for young investors, made me realize that an article on the subject might be a good idea.

There are essentially a few major ways for an ordinary investor to accumulate a nest egg. The first way is by contributing or maxing out your 401k and IRA, and let it compound tax-free for several decades until you reach your target retirement date. At this stage, you can follow the traditional four percent rule. Or you could decide to embrace dividend investing by selling your index funds and purchasing individual dividend growth stocks. This could be done a few years prior to your target retirement date on several tranches. For example, if you have a $600,000 in a 401k and five years to retirement, you can essentially sell $1000 worth of index funds and purchase $1000 worth of dividend stocks every month for 60 months. The value of your index funds will fluctuate as you perform this exercise, and the mathematics will be different for every investor, but the idea should be fundamentally sound and easy to follow. Of course, you can decide to convert your 401K by selling off your index funds, rolling the proceeds into an IRA, and then buying as much dividend paying stocks as you can get your hands on. I rolled over an old 401K in April, and replaced the index funds with a portfolio of twenty dividend paying stocks.

Below, you can view the annual contribution limits for 401K plans for individuals below 50 years of age since 1987.

If you maxed out your 401K between 1987 and 2012, and invested in an S&P 500 index funds (VFINX), your portfolio would be have been worth over $738,000. I assume dividends were automatically reinvested during those 25 years, and all of the money was invested at year-end. I do not account for any catch up contributions in this scenario.

The second way to accumulate your nest egg is to focus on income only. You can put the bare minimum in 401K or IRA plans, and then invest most of the funds in a taxable brokerage account In this account the investor will be able to invest in anything they want, and have the flexibility to either spend the dividends or reinvest them in more stock. This is the ideal method for anyone who plans on retiring in their 30s or 40s. With this method however, the accumulation of funds might be slower than with the first one, since it is done with after-tax money. As I mentioned in an earlier article, someone who is saving $3,000/month in dividend growth stocks yielding 4% and growing distributions at 6%/year should be able to generate $4,000/month in 15 years. If you put $1,000/month, in 15 years you would be able to earn approximately $1,330/month in passive dividend income.

The types of dividend stocks I could purchase today, which would allow me to pursue option two include:

Philip Morris International Inc. (PM), through its subsidiaries, manufactures and sells cigarettes and other tobacco products. The company has raised dividends for 5 years in a row. Over the past five years, Philip Morris International has managed to raise dividends by 13.10%/year. The stock trades at 16.90 times earnings and yields 3.90%. Check my analysis of Philip Morris International .

Wal-Mart Stores, Inc.(WMT) operates retail stores in various formats worldwide. The company has raised dividends for 39 years in a row. Over the past decade, Wal-Mart Stores has managed to raise dividends by 18.10%/year. The stock trades at 14.70 times earnings and yields 2.50%. Check my analysis of Wal-Mart.

McDonald'’s Corporation (MCD) franchises and operates McDonald's restaurants in the United States, Europe, the Asia/Pacific, the Middle East, Africa, Canada, and Latin America. The company has raised dividends for 36 years in a row. Over the past decade, McDonald’s has managed to raise dividends by 28.40%/year. The stock trades at 18.60 times earnings and yields 3.10%. Check my analysis of McDonald’'s.

Chevron Corporation (CVX), through its subsidiaries, engages in petroleum, chemicals, mining, power generation, and energy operations worldwide. The company has raised dividends for 26 years in a row. Over the past decade, Chevron has managed to raise dividends by 9.60%/year. The stock trades at 9 times earnings and yields 3.40%. Check my analysis of Chevron.

Realty Income Corporation (O) is a publicly traded real estate investment trust. It invests in the real estate markets of the United States. The company has raised dividends for 19 years in a row. Over the past decade,  Realty Income has managed to raise dividends by 4.20%/year. The stock trades at times FFO and yields 5.20%. Check my analysis of Realty Income.

A third way is to follow a blend of contributing out 401K and IRA contributions, while investing any remaining amounts in taxable brokerage accounts. I am somehow following this strategy today, as I max out tax deferred accounts in order to get the most tax benefit today, while adding any additional funds to taxable accounts. This was difficult to implement 5 - 6 years ago for me, but now it is easier.

For the first five - six years of my dividend investing pursuits, I purchased almost all of my investments in taxable accounts. As a result, I have been able to accumulate a dividend income stream, which can cover over 50% of my expenses. This income stream is somewhat tax efficient, as the top rate on dividends is approximately 20%. In addition, the taxable brokerage accounts provide me with a lot of flexibility, as I can withdraw money at any time from my margin balance if I have a short term need for funds. I can also sell stocks short, sell naked puts and buy stocks on margin. I do not do those things, except for selling options, but it is nice to know you have options. I do have to pay taxes every year on the dividends I earn and capital gains I realize. However, if someone is just starting out in investing, I strongly encourage them to start small in a taxable account, while taking advantage of 401 (k) plan company matches. That way, any mistakes you make in your brokerage account will be deductible on your tax returns. The distribution stream from a taxable account will also provide you with a nice buffer of income when you build your early retirement dividend machine.

This dividend income stream is what will allow me to allocate so much money to max out my 401k and SEP IRA. Earlier this year, I discussed that I am now maxing out my 401k and am also planning on maxing out my SEP IRA. The goal of this exercise was to reduce the amount of taxes I pay each year. Unfortunately, I am not eligible to receive a tax deduction on the regular IRA at this time. I realized that I would much rather have a large amount of money sitting in a tax deferred account to my name, rather than pay taxes and receive no specific benefit attributable to me. I understand that in order to access this money I will have to jump through hoops such as early retirement penalties as high as 10%, in addition to paying ordinary income tax rates to withdraw the money before the age of 59.50 years. I will convert the 401k plan into a regular IRA at my retirement date, if I choose to leave current employer.

With 401k plans, there are limited investment options, such as index funds or target date funds. However, by rolling over the funds from a 401k to an IRA when I retire, I should be able to invest in individual stocks. Some 401k plans might also have a brokerage window, which would allow investors to buy individual stocks. I have to research to see if my provider offers this option, and what the costs associated with it are.

If I retire in five – six years, I can take out Substantially Equal Period Payments (SEPP) if I really needed to withdraw distributions from an IRA. It looks like the amount that I can take out in 5 years would be equivalent to somewhere close to 2.50% -3% of my net account value. If my dividend stocks in the IRA yield more than 2.50%, then I would essentially have a stream of income that would compound for life. I would essentially have distributions that are growing each year because companies are raising them, and also excess dividend checks would accumulate and would have to be invested into more shares. All of this money that is retained in the IRA would compound tax free for decades, until I reach the ripe age of 70.50 years. At that time I would have to take mandatory withdrawals, and pay ordinary taxes on it.

Relevant Articles:

Check Out the complete Archive of Articles
Dividend Growth Investing is a Perfect Strategy for Young Investors
Twenty Dividend Stocks I Recently Purchased for my IRA Rollover
Six Dividend Paying Stocks I Purchased for my IRA

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