Friday, October 25, 2013

My Retirement Strategy for Tax-Free Income

This is the last article on taxes for the week. Hopefully you enjoyed articles one, two, three and now four. Please make sure to read the other three articles, before checking this one, because it is a continuation of them all.

In my retirement strategy, I currently have the bulk of my funds in taxable brokerage accounts. They are producing approximately enough dividend income to cover 50 - 60% of my annual expenses. As I am maxing out 401 (k), Sep IRA and Roth IRAcontributions this year, this leaves less to be put towards my taxable dividend portfolios. The tax savings are more than worth it however. If I were a fan of Early Retirement Extreme and worked for 4 years, while saving $17,500/year in a 401 (K), the tax benefits would be equivalent to me working over one whole year. I would end up with a total of $17,500 in savings in a taxable account merely because of my marginal tax rate of 25%. This is in addition to having the contributions for four years in the 401 (k).

I expect to be able to not have to work in a traditional job environment by the end of 2018. By this time, my dividend income would likely be covering 100% of my expenses. This is because I expect dividend growth of 6 – 7% in my dividend portfolio, which continues to be reinvested in dividend paying stocks whose average yield is somewhere in the 3% - 4% range. Currently, it covers approximately 50 – 60% of expenses.

I am also expecting that I would earn some money on the side in a 1099 capacity after my retirement date, although I am not counting on it. Of course, if I have all the free time in the world, chances are I could write a book on dividend investing, start a stock picking paid service, create and run a low cost dividend mutual fund or start a TV show on dividend investing ( to name a few possible items). Or I could get really bored and start advising persons on financial and tax matters for a fee. This extra income however, would not be spent but merely end up accumulating. Since I would consider myself retired, and already have dividends covering my income, this would mean that some of my assets would need to be put in a tax deferred account today. Otherwise, I would be drowning in cash, and would be paying too much to the tax person for years. For example, if I make $24,000 in annual dividend income, and $24,000 in contracting income, but only need $24,000 to live on, I am essentially earning too much. If I made the dividends in a tax-deferred account, I could therefore choose to withdraw them as I please (or as I need the money to live on). It doesn’t make sense to pay taxes for dividend income I am not using, especially if it is in a taxable account. In a tax-deferred account, the money will compound tax-free for decades.

Therefore, the optimistic scenario is that I max out contributions and keep the 401 (k), Sep IRA and Roth IRA to compound tax-free for several decades. If I do not make too much money from dividends and side hustles once I retire, but enough to live on, I would start rolling over portions of my 401 (k) into a Roth IRA. I would try not to pay more than a 15% tax on that rollover. I expect that within 3 – 4 years after retirement, I should be able complete the conversion process. After that, I might also consider rolling any IRA and Sep IRA accounts over to Roth, depending on balances and my tax situation.

However, if I end up making too much from my dividend stocks and side hustles, I would likely have to simply roll those 401 (k) amounts into a regular IRA, and slowly convert it into a portfolio of dividend paying stocks. I expect it to compound tax-free for several decades, until I reach the age of 70.50 years old and have to take required minimum distributions. Since I have several decades before I hit that age, this could potentially be a large tax hit. Of course, I would much rather use any trick under my sleeve to accumulate as much cash as I can to generate as much dividend income, in order to achieve my goals of retiring early. The trade-offs are well worth it.

This is because it is much better to accumulate $17,500 in a 401 (k) in a single year, rather than accumulate only $13,125 in a taxable account for the year. In addition, I am somewhat protected from increases in tax rates on the amounts that would stay inside tax-deferred accounts. If tax rates on dividends and capital gains increased to match ordinary income rates, this could be bad for retired dividend investors. Of course, I do not know where tax rates are going to be 30 – 40 years from now, which is why I try to diversify against the risk of higher taxes by shifting some of my assets to tax deferred types of accounts.

Last but not least, I fully expect my taxable accounts to be able to cover my expenses in 4 - 5 years based on current levels, and projections for reinvestment at yields of 3 - 4 % and dividend growth of 6 - 7 %/year. The excess is going to tax deferred accounts ( 401K, Sep IRA and Roth IRA), which would likely be able to cover somewhere between 25% - 33% of expenses above 100%. This would be the reserve account in case my dividend income does not grow at or above the rate of inflation or if I experience too many dividend cuts for whatever reason. Another reason for the reserve is that I might end up spending more than I initially projected. Since I am hoping not to have to touch this "reserve fund" unless something unexpected happens, it is much better to be in a tax-deferred account, and it won't generate tax liabilities on income i don't need.

After reading all four articles on tax deferred accounts, I hope you learned the general overview of options available to you outside of taxable accounts. I also hope my take was helpful.

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


  1. What are your thoughts on after-tax 401k contributions vs Roth IRA contributions?

    I currently max out my 401k contribution, and the old-guy extra $5500/year Catch Up contribution. I also plan to add about $21000 to my after-tax 401k.

    My company also continues their matching contribution on my after-tax contributions so it is a pretty good deal.

    Based on their offering the match on after-tax and the ability to to contribute a much larger amount to my retirement savings, I decided to go the after-tax 401k route rather than a Roth IRA.



  2. DGI,

    Excellent series of posts with some great insight on tax advantaged strategies. Good luck with your 2018 goal. That's a lot of writing this week, I think you deserve a few days off!


  3. It would be helpful to know what you expect your dividends to deliver for your annual income. If you're pulling down less than $25,000 a year, you're probably be living in a mobile home park.

    That's the missing piece of the puzzle in your pieces.

    Are you willing -- or able -- to state this? For myself I need $1.5 million @ 5.5 percent (av.) to provide $82,500. This does not include my home that is vlaued at $1.2 million, but on which I have a $130,000 mortgage.

    I want to maintain the standard of living that I currently have, and I do not want to downsize my home and I do want to maintain my current lifestyle, which includes 2 vacations a year and financial peace-of-mind.

    $25,000 and a mobile home would not do this for me. So what is your financial situation, after all this blog is amoung finance, isn't it? Full disclosure, please.

  4. Hi Anon,

    Unfortunately I don't think Roth 401K is available for everyone ( that includes myself ;-() . It looks like a nice thing to do. But basically, I am trying to get a deduction today with 401K (regular), and then pay almost no taxes later on by doing a Roth Conversion. It would be nice to be able to put $21K/person in a ROTH 401K, I wont lie to you. However, everyone's situation is different..So I unfortunately do not know what option is best for you ;-(


    I actually write some of my posts months in advance.. I have a huge backlog of posts for at least 1 year now.. After I started keeping a notepad with me at all times, any ideas I get are written down ( even if they are bad, they are written down too ;-) )

    1. Will you start doing roth conversions when you retire or when you don't make enough to max out your roth contributions from your income?

  5. Michael,

    Those are great questions. I generally do not disclose numbers, and information about myself, because I am not anonymous on the internet. For safety reasons, I am keeping my numbers, name etc confidential.

    However, in most cases, this should not matter to the reader whether I am a millionaire or a thousandaire.

    I hope that the articles I post on DGI site, inspire readers and help them identify things they can learn and apply in their own lives. For example, whether your portfolio is valued at $20K or $200K or $2M, you should probably follow a similar strategy in managing it. Therefore, asking myself about income, portfolio size etc, should not matter to you as a reader

    The other reason I do not use specific numbers is because of past reactions by readers. When I discussed investing $3000/month in an article, readers were enraged that this amount is too high. I was called names, and told that I was out of touch with reality. I then stupidly decided to illustrate the point that it is possible to build a diversified dividend portfolio $200 at a time in 20 something positions, using ROTH IRA contributions for 2013. It was stupid of me for assume that all people can use a concept and apply it to their own situation. Now I have a few readers who are being obnoxious, because they believe that this amount is too little. One of the most ridiculous comments I received from a reader is when they try to insult me, by telling me that what I say does not matter, because I supposedly only buy one share at a time. This is something that is pretty dumb to say to someone, particularly because they are the ones coming to my site, and not the other way around.

    I am not trying to be rude or anything, I am just using the above paragraph as an example of the negativity I deal with in the background of this site. As a result, I am not going to disclose specific numbers about myself, because this should not matter to readers. This is also done to protect readers from themselves, because by disclosing specific numbers, they will be focusing on the wrong thing. For example, if I bought 400 shares of ARCP at 12.50, that is a $5K transaction. The focus of conversation would somehow shift to how much $5K is, and how rude I am to flaunt my success. If I bought 20 shares for $250, this meaningless data point would be ridiculed. In reality, the conversation should be whether ARCP is a good or a bad investment idea, according to fact.

    As far as your other question, it is all relative whether someone can live on $25K/year. For a young couple with no kids in the Midwest, who owns their home and paid off the mortgage, it is very doable. For a single person living in NYC or SF, it is pretty much impossible. In some parts of the world, earning $25K/year you would be considered royalty ( exaggerating, but you get the point) This is a personal choice that people have to make. Once again, the articles I write are for people to use as ideas to see if they apply in their situations. There are a couple thousand people reading the site per day, and I can guarantee you that every one of them has a situation that is different than yours.

  6. I appreciate what you are saying, but I have to disagree that providing the amount that you invest in a stock should not matter. It does. For instance, if you state that you bought 10 shares of XYZ Inc. for $10 that is a $100 investment. If, however, you said that you bought 200 shares at $10 that is a $2,000 investment and speaks highly of your faith and confidence in this stock than a $100 investment.

    As for buying one share in a company, unless it's akin to BRK.A at $175,000-plus, I would not consider this as being meaningful.

    I wonder what other readers think?

  7. I have read all four articles.

    I suggest that if you can may enough money to forgo using these retirement accounts, do it. Don't use these accounts.

    Unfortunately, sometimes you are forced into them because part of your compensation is tied up in matching funds that you would lose.

    The reason is that the complexities of these accounts outweigh the benefits unless you want to become a creature of the tax code.

    I'll give you an example. Let's say you have a 401k, and you roll it over to an IRA. Then you add to the IRA subsequently. Simple, right?

    Well, no. In some states you get tax deferral on 401K contributions but not the IRA contributions.

    When you pull the money out, you need to allocate money to each bucket: taxable contributions, taxable earnings, and untaxable contributions. If you convert to a ROTH you need to make sure you don't pay taxes on the IRA contribution money for your state.

    I recently rolled over a 401K that had after tax money - actually not a common situation but it occurs. Guess what, you can take that money free and clear. My accountant didn't know this and had tried to get me to pay taxes on it again.

    I won't even get into the details of converting a 401K to a ROTH IRA if you already have a tax-deferred IRA. Ridiculously complex.

  8. Michael,

    I didn't think of it from that perspective. I used to put something like I bought half a lot/position in a stock or a full lot/position in a stock. Thus meaning that a half lot position might be something like $1K, whereas full lot would be double. The lot was the building block of a portfolio for each stock owned, and could be comprised of several lots for each position.

    I guess if I said $100 or $1000, this might be irrelevant if my portfolio size was equivalent to yours though.

    Either way, interesting idea to show my confidence in a security.

  9. SFI,

    You raise some good points about tax-deferred accounts. They are complex, and should be done after discussions with a CPA.

    But I think that the conversion of 401K, where all contributions were pre-tax, to a ROTH is straightforward. In my research, I read how rolling an IRA into a ROTH might be more challenging from a calculation perspective.

    Either way, a good CPA can probably help. However, based on discussions with readers, it seems that most of them have had terrible experiences with tax advisers. I had an elderly gentleman, whose CPA advised them not to invest in pipeline MLPs merely because of increased complexity of the tax returns. And this gentleman is a millionaire dividend investor.


  10. I wanted to say something about the use of "personal data" and the merits of someone's advice.

    You have to examine what is said, or written, with how it relates to the message at hand.

    What everyone has access to, as far as investable capital is concerned, is unique to their present situation.

    Time and money are closely tied.

    Reducing your expenses by $1 can go as far, and even farther than earning $1 more.

    Almost everyone needs motivation to continue to do things that others around them do not presently do.

    Like exercise, being in control of your finances requires discipline.

    No one has all the answers, and we can all better our understanding and education by being open, and humble, and receptive to others.

  11. I enjoy reading any ideas for optimizing investment dollars. Although your goals don't fit mine, it was an interesting real. One thought: in a prior comment, you mentioned not being able to convert 401(k) money into IRA money while still employed at that job. Some plans may offer "in-service withdrawal" feature -- it's worth looking into (there will be restrictions). I myself didn't even know my own employer's plan offered this until someone else pointed it out. You could take an in-service wdr into a rollover IRA.

  12. DGI,
    I for one prefer to see your ideas and research, not dollar amounts. Your ideas have been used here successfully, though I don't always agree with a particular company you may have invested in, the education you provide is worthwhile in any case. As I have said to you before, you have given me focus in investing, which I did not have before. So I don't care how much money you have, how much you invest and don't need to hear it. Such information does not help me to see your commitment to a particular company at all. The ideas are most important to me.

    Best of luck,

  13. DGI,

    Allow me to point out one other thing with regard to Michael's comment on dollar amounts, the amount of your portfolio, etc.. I want to remind you that many many times, you have focused in on 'growing income' during retirement, that dollar amounts invested are not important. In Michael's case, if he has $1.5M invested at 5.5%, it is a static amount of income he generates every year and does not grow. If they are invested in dividend stocks, with 7% growth in the dividend itself, he maintains income during retirement, even beats inflation. What's important is not the $82,500 he says he needs in retirement, but that in ten years it's $160k. And whether some of the $1.5M is invested in cash and bonds for stability is another conversation. The lesson from your blogs, your teachings, is the need for growing income in retirement and how one might accomplish it.

    Thanks again,

  14. This was very timely. I have recently realized, like you, that I need to be doing more to shelter tax expense and so we've decided to max out our 401k allocations going forward. The key part that was missing was how do we eventually pull out the distributions while minimizing tax expense. The 401k to Roth IRA conversion provided some useful ideas.

  15. Thanks DGI. Being late on the investing strategy I may reconsider investing in a taxable account. As it grows so will my age and if funds aling with age 60 it would have made more sense to have kept everything in tax free accounts the whole time.

  16. I greatly appreciate your time and effort put into this series. It resonates with me because I too am trying to find Financial Independence much earlier than the average Joe.
    I will have the opposite problem upon approaching early retirement as the majority of my investments will be in my current 401k plan. I have been maxing out my contributions for a few years now and it is growing quite nicely.
    My plan is to hit FI in 6-7 years and then transfer this to a Trad IRA. The trick will be balancing the transfers to Roth IRA while staying in the 15% bracket.
    MadFientist has a great write-up as well on this process.
    Thanks for your work.


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

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