Tuesday, February 10, 2015

How to buy dividend paying stocks at a 25% discount

Most dividend investors that I know of, spend most of their time screening for companies that fit their criteria, and then research the result, in order to identify quality companies available at good prices. This is the correct way to behave of course, if you want to achieve your dividend retirement goals. I have been following this strategy for the past seven years, and am a living proof that this strategy works. What can be better than putting money to work in great companies available at good prices, getting paid rising dividends every year and then reinvesting those growing distributions into more shares that result in more dividend income each year.

I used to practice my dividend growth strategy for the first four - five years exclusively in a taxable account. My goal is to be able to earn enough in passive dividend income that would cover all of my expenses. After that, I will have the flexibility to do what I want. There as a problem with this sort of thinking however, that I was able to start rectifying in early 2013.

The problem is that I am in the 25% bracket in the eyes of the IRS. This means that for every additional dollar that I earn from employment, I get to pay 25 cents to the IRS. This means that I get less money to buy quality dividend paying stocks. That’s 25% less money to buy quality dividend paying stocks, which means I will be earnings 25% less in dividend income every year.

The other sad part is that in the accumulation phase, I will also pay 15% tax on any dividends I receive. This translates into less money to put in my dividend machine, and less money to compound for me in the long-run. I do not like waste, but that 15% tax sure looks like it. Of course, the amounts start being noticeable after 4 – 5 years of meticulous saving, investing and reinvesting your money, and growing it wisely. It is little consolation that if and when I do decide to never work again for money, my income will be tax-free, because qualified dividends are a very tax efficient way of earning income.

Unfortunately, everyone has to pay taxes. However, it is possible to legally defer taxes. One can put money in a 401 (k) or an IRA, and legally defer taxes for several decades. If I can go through an example, imagine that can afford to save$10,000/year after all taxes and other expenses and that I am in the 25% tax bracket. I can essentially put it in dividend paying stocks yielding 3% and earn $300 in gross dividend income per year or $255 in net after-tax dividend income. However, if I put that money in a 401 (k) or an IRA, I will be able to put $13,333 in dividend paying stocks, and earn $400 in annual dividend income. This is because I am putting pre-tax money to work for me.

In the first example, the portfolio can buy 250 shares of Coca-Cola (KO) at $40/share. In the second example, the investor in the tax-deferred account can buy 333 shares of Coca-Cola at $40/share. Therefore, the first investor who does no tax planning ends up with 25% less shares in Coca-Cola permanently. If the first investor wanted to own the same number of Coca-Cola shares as the second investor, they need the share price to drop to $33.33/share. Hence in essence, the second investor is able to purchase shares at a 25% discount.

In previous articles I have discussed how it is possible to take advantage of tax-deferred vehicles such as 401 (k) plans, IRA’s, and HSA’s in an effort to legally minimize taxes today, and have more assets working for the investor. Later on, it could be much easier to convert those assets into Roth IRA’s, if the investor is mindful of certain income thresholds, without triggering too much in tax liabilities. Of course, tax laws change, and everyone’s tax situation is very different, which is one you should not treat this article as advise to you to act on, but you should talk to a tax adviser that could be able to help in minimizing taxes and maximizing investable assets.

It is very interesting to me that some people spend all of their time and energy trying trying to pick an extra point of dividend yield, but ignore the fact that taxes take a large chunk out of your portfolio. If people spent more time optimizing their taxes, without sacrificing investment quality, they could end up being much better off overall. It is particularly striking that the second investor is essentially ending up with 33% more shares in Coca-Cola than the first investor. Over a period of 3 years, the first investor would have been able to put $30,000 to work for them, while the second investor would have been able to put $40,000 working for them. This means that every 3 years, the second investor is able to save an extra amount that is equivalent to an extra year’s worth of savings.

It is also interesting to observe people who save the money after paying their fair share of taxes, and then accumulate their cash waiting for lower prices. Many of those investors would only put money to work after a 20% correction. I believe that money should be put to work, as soon as they are available to use. In addition, I believe that those who are waiting for a correction, do so only to bolster their egos, rather than try to intelligently allocate capital. There are always opportunities available to invest, which is why I believe those waiting for corrections to have egos, preventing them from fully recognizing the full potential of their capital. If those investors were to utilize tax-deferred vehicles such as IRA’s or 401 (k)’s, they would be able to effectively acquire ownership interests in quality companies at an effective 25% discount.

Of course, this exercise of putting money in tax-deferred accounts is not an excuse to willingly overpay for shares in quality dividend paying companies. Just because you end up with more money using a tax-deferred account, doesn't mean valuation models and due diligence should be thrown out the window. The same entry rules, diversification rules and stock analysis rules apply.

I understand that not everyone has access to a 401 (k) plan that allows them to purchase individual companies. However, given the fact that employees today switch jobs frequently these, it is quite possible that those who put the maximum to their plans today might be able to roll them over into IRA’s when they leave current jobs and invest the money in individual companies. For everyone else, it is possible to take a deduction using regular IRA’s, HSA’s or SEP and SIMPLE IRAs. If you are lucky enough to be self-employed, you can start your own 401 (k) plan using a service such as Fidelity, and possibly defer even more than the $18,000 available for those under the ages of 50. Either way, the important thing is to get you thinking that one doesn't need to save hard, they need to save smart.

I believe it is much easier to save a nest egg that will produce sufficient annual dividend income using a tax-deferred approach, than save that with a taxable brokerage approach. When the investor utilizes tax-deferred accounts, they have more money to work for them, and to compound tax-free for decades. Taking money out of those accounts is not usually an issue, but requires the need to educate yourself how to withdraw money without triggering penalties. Education is a must, since there are different types of accounts, with different rules around them. Learning those rules, and successfully applying them, could result in significant money savings for the time involved. The important thing to remember is that if you pay too much in taxes, that money is lost forever for you and will never compound for you. However, if you get any tax break possible, and invest the money intelligently, one has a better shot of achieving financial independence.

In my case, I plan on getting as much in deductions as possible today ( from 25% - 32%), compound the money tax free for years, and then slowly convert the money into a Roth IRA, without triggering any taxes in the process of conversion.

Full Disclosure: Long KO

Relevant Articles:

My Retirement Strategy for Tax-Free Income
My Dividend Goals for 2015 and after
Dividends Provide a Tax-Efficient Form of Income
Roth IRA’s for Dividend Investors
How to generate income from your nest egg

20 comments:

  1. President Obama just submitted his 2016 budget to tax HSA withdrawals, stop Roth conversions, and set maximum limits on IRA accounts. Although these ideas will be rejected by the current Republican congress, a future congress controlled by Democrats or Obama executive actions will use class-envy hatred to destroy our retirement savings plans. America is broke and the liberal politicians have their eyes on the trillions in tax-free Roth accounts because they are "stealing" from the federal government.

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    1. If what you are saying is true, and taxes are indeed going up, then those who pay taxes on taxable investments will be hit much harder. Getting to $3M in a 401K is going to take 30 - 40 years of maxing out the account. For most individuals - this is not going to be a problem.

      Plus, I don't think taxes on retirement accounts will go up in the next 2 - 3 years ( we have elections in 2016).

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  2. Your common sense approach to dividend investing deserves a big THANK YOU. Barry

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    1. Thank you for stopping by Barry and good luck in your dividend investing journey!

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  3. As I understand it, money contributed to a 401k is not taxed. As a result, when those funds are eventually withdrawn from the 401k account, the government will want to tax you on the withdrawal. I'm pretty certain that rolling funds from a normal 401k to a Roth IRA will also count as a taxable event as a Roth IRA is supposed to be comprised of after tax money. That said, if a rollover/conversion is indeed a taxable event, how will you accomplish this without triggering any taxes during the conversion?

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    1. You are correct. However, when most people retire/become FI, their income drops and is lower than before. Therefore, in retirement, I expect to be in a lower tax bracket than 25% - most probably 10% or 15%.

      For example, if I were married, we could earn $70,000 in qualified dividend income, and rollover $20,300 from 401 (k) to a Roth IRA, and not pay ANY federal taxes. Plus, I could have booked $3,200 worth of long-term capital gains, and we still wouldn't have owed any taxes under current tax laws.

      The end result will of course depend on a variety of factors. This is why I say, one needs to research the tax law ( or speak with a tax professional) in order to make the best plan for their situation.

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    2. Thanks for the additional info/clarification! I appreciated you taking the time to put your thoughts in writing. It helps to make me think of things I otherwise wouldn't.....

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  4. There is certainly some value to maximizing your tax efficiency, especially when there are opportunities available to limit your tax liability without losing long-term access to your capital. For me, I take a hybrid approach, leveraging both taxable and tax-deferred options.

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    1. One of the biggest misconceptions that people have is that money in 401K, IRA, Roth is locked and therefore not easily accessible. There are multiple ways to access that money early, without paying a penalty. This is why I encourage people to learn as much as possible about tax deferred accounts.

      Good luck!

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  5. I stay fully invest in my tax deferred accounts, however I maintain a cash position in my taxable account.

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    1. Chances are that even after maxing out tax-deferred accounts, and investor will still be able to accumulate substantial amounts in their taxable accounts.

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  6. This was very enlightening, thanks. I stopped investing in my 401k last year, because of the fees and a poor company match (0.25%! I didn't want to endorse that). BUT I should have been investing post tax in my IRA and taking the deduction at tax time instead of simply investing post-tax in my Roth and other accounts. Thanks for this. I'm rethinking my strategy.

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    1. Depending on 401K plan, it is always worth it to at the very least invest to get the match. Some are terrible, full of loaded funds with high annual expenses. Everyone's situation is different. The goal is to get you thinking of the best way that you can improve your situation.

      Good luck!

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  7. I agree with Paul I. above. Your comment: "then slowly convert the money into a Roth IRA, without triggering any taxes in the process of conversion." How is that possible, I thought any money converted to a Roth from a traditional will be taxed at your current income tax bracket at the time/year of conversion. So how is it possible to convert any of those funds without triggering a tax.

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    1. Please check the reply to Paul above.

      If you know the rules, you can pretty much do anything within them. What I am saying does not even touch the basic level of complicated stuff that some people have done, including setting up private pensions, forming up LLC/S-Corps etc.

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  8. I am confused about your "no federal taxes" up to 70 plus thousand dollars. When I look at the federal tax brackets it shows 10% up to 18,150 and 15% up to 73,800.. Could you please elaborate. I assume I am missing something.

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    1. Please read my response very carefully. I talk about qualified dividend income. Please research how qualified dividend income is taxed. You might like this article:

      http://www.dividendgrowthinvestor.com/2013/12/dividends-provide-tax-efficient-form-of.html

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  9. Good point on tax deferred accounts. Tax planning is definitely something everyone needs to consider regardless of when they plan to retire. How much to contribute to tax deferred accounts depends on everyone's situation - whether they have high expense ratios in their 401(k) plan, whether they want to retire early, and/or how much take home pay they need. For example, if a person maxes out his/her 401(k) plan, he/she may not have any money left to invest in dividend growth stocks.

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  10. I don't think I will be able to deduct my traditional IRA contributions. Here's what TT is telling me "
    Your modified adjusted gross income (MAGI) is $141,003, which puts you over the limit for IRA deductions. To deduct a contribution, you can't have a MAGI of over $70,000 while being covered by a retirement plan at work" does this sound right?
    Great post, keep up the good work.

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  11. I sit in the 15% bracket mostly because of my house. Without it I would be in your shoes. As the years pass I imagine I will have to reduce my income other ways just like you to stay in a lower bracket.

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