Wednesday, October 23, 2013

Is Dividend Mantra Wrong on Taxes?

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

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

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

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

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

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

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

Full Disclosure: None

Relevant Articles:

Why I Considered Tax-Advantaged Accounts for My Dividend Investments
Roth IRA’s for Dividend Investors
Six Dividend Paying Stocks I Purchased for my IRA
Twenty Dividend Stocks I Recently Purchased for my 401 (k) Rollover
Eleven Dividend Paying Stocks I Purchased Last Week


  1. So would you only advocate investing in tax deferred accounts and then taking the early withdrawal penalty as long as your taxable income will be low enough to have a 0% tax rate?

    I think it would be an interesting calculation to see how much more you will accumulate by your retirement target date by avoiding taxes and taking the penalty compared to just paying taxes along the way

    Unfortunately I think my goals and standard of living that I prefer would cause me need of a higher income. Probably why I have plans to work longer and am not striving for super early retirement.

    It is interesting that you can withdrawal from a 401k at 55 or a IRA at 59.5 without the penalty. I'll have to look more into that because those would be the ages I believe I would want to begin thinking about retiring.

    Great series so far!

  2. Did I just read this right, "If you do not have any taxable income, you would keep the whole $393.75 in dividend income, without paying any taxes?" You can possibly pay $0 income tax on dividends? I had to do some research and it seems that as long as you are in the 10 or 15% tax bracket, you pay $0.00 income tax on qualified dividends...and my dividends are qualified!??!?! I feel like this is Christmas. Please tell me it is true!

  3. DGI, I really enjoy your site, and I think you have some valuable ideas and insight.

    If I had one minor piece of advice to help make your blog even more enjoyable and easier to read, it's the font and text spacing. The sentences are so tightly compressed, it makes it harder to get through the content. Since you admire his work, take a look at DM's site. It appears he uses about a 1.5 spacing with Arial font, and it's easier on the eyes. Just my two cents.

    Keep up the great work on the blog!

  4. It would be interesting to have a follow-up article for someone with different goals. For example, I am currently making $60k in Canada. My goal is to retire with a HIGHER salary than I currently receive.

    In this scenario, my retirement salary would probably be in a higher tax bracket than I am now. In Canada, the 401k equivalent is an RRSP, and an IRA I believe is similar to a TFSA (tax free savings account).

    My belief so far, is if I have half my retirement savings in TFSA (which is NOT taxable on withdrawals, and has NO penalty for withdrawals before retirement, but is accumulated with after-tax savings), and half in an RRSP (pre-tax savings off my paycheck), I would be taxed at half of my total retirement income (only taxed from RRSP withdrawals), therefore ensuring I remain in a lower tax bracket despite making sufficient money from dividends to be in a higher tax bracket.

  5. Dan,

    You might want to check the last piece about my essential strategy for using tax deferred accounts.


    The best of my knowledge, currently a taxpayer in the 10/15% bracket does not pay federal taxes on dividend income. State taxes might vary. Also, I am not a tax adviser, so take this information with a grain of salt.


    Unfortunately I am not based in Canada, and therefore my knowledge of Canadian retirement accounts is terrible.

    Next Anon,

    I would try to work with the settings. Please stay tuned

  6. I realize this is an old post and this might not get answered, but if I read this right, if I have a 401k that is spitting off enough dividends (qualified) to live off - I would only get taxed at 15% assuming I was 55? That sounds like something to strive for!


Questions or comments? You can reach out to me at my website address name at gmail dot com.

Popular Posts