Wednesday, December 3, 2014

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
Kinder Morgan Partners – One Company three ways to invest in it
Roth IRA’s for Dividend Investors
Six Dividend Paying Stocks I Purchased for my IRA

9 comments:

  1. I like your Roth early retirement transfer plan. Makes sense for those living a simple life in a low tax bracket. Thanks for the article.
    DFG.

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    Replies
    1. It would be really nice if I manage to get the deduction today, and then convert to ROTH and pay minimal if any taxes on the conversion. But if laws change, I will have to reevaluate. Thx for stopping by

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  2. DGI,
    I am lucky that I can buy stocks in my 401k with almost no limitations except that we cannot buy stock in companies that do business with the company that I work for. Guess that prevents a conflict of interest, so it makes sense. Otherwise, we can buy almost anything. However, much as I would love to own Nestle stock, the fact that I would lose the Swiss taxes withheld from the dividends has kept me from putting money there. I do own UL and BBL for exactly the reasons you cited.

    I have to figure out the 401k and Roth IRA withdrawal requirements when I retire at the end of March. Right now I'm just reinvesting the dividends and don't plan on making any withdrawals until I'm 62 or older. Should have time to work through the possibilities by then (since that will be 2019 or later).

    Thanks for another great article. Have you been working on your writing skills? ;)
    KeithX

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    Replies
    1. Hi Keith,

      It is nice that you have so much flexibility with your 401 (k). I am limited to mostly index funds with mine. I agree that some companies might not be well suited for a retirement account - Nestle is a prime example.

      As for the withdrawal requirements, if you do not need the money, and you do not make too much, it might make sense to start converting a portion from 401k to Roth. The goal of course is to pay as little in taxes on the conversion as possible.

      As for the writing part - I am not a very good writer but I will take any compliment. Unfortunately, this site is my "hobby", and therefore it is last in priority after family time, job, investing etc. I basically post it as I think it out loud, with minimal editing. I would much rather spend 80% writing and 20% editing than vice versa ;-) You should start your site.

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  3. Any guesses as to whether or not the drop in oil prices will affect big oil's dividends?

    ReplyDelete
  4. Hello Dividend Growth Investor,

    I have seen you refer to the age at which there is no penalty for early withdrawal for 401K to be 55. According to IRS.gov, the age is 591/2, same as an IRA. Source: http://www.irs.gov/Retirement-Plans/Retirement-Plans-FAQs-regarding-Substantially-Equal-Periodic-Payments

    The exception as you have notced involved the "Substantially Equal Periodic Payment", but again, I do not see anything about a specific age. I am just wondering where you are getting the 55 age as being significant. I ask because I have heard that before, I simply cannot find any IRS documentation that confirms that age 55 for 401K is penalty free withdrawal and am simply trying to locate the official source.

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  5. I made a quick google search: http://www.irs.gov/taxtopics/tc558.html

    As for the previous anon, I am posting something on energy next week.

    ReplyDelete
    Replies
    1. Look forward to the analysis of energy companies.

      Delete
  6. Also this table is helpful:

    http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Retirement-Topics---Tax-on-Early-Distributions

    Apparently there is a 401K exception after "age 50 for public safety employees in a governmental defined benefit plan"

    ReplyDelete

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