Monday, January 11, 2016

Living off dividends in 2016 – My New Goal

I posted my goals for 2016 a few weeks ago. After some changes that I became aware of subsequent to posting the article, I have some changes.  I have had some change in plans about my goals for 2016. I have decided to essentially live off dividends in 2016. I will be spending my dividend income that comes from my taxable accounts. My annual expenses are close to $18,000 – 24,000/year. My taxable dividends are approximately $10,000 - $11,000/year ( out of $14,000 - $15,000 in total dividend income). The shortfall could be covered by any side income activities I engage in.

I have decided to try and save my entire paycheck in 2016, after taxes of course. I will manage to do that by taking the maximum contributions to my 401 (k) and Health Savings Account (H S A) plans. After speaking with several reps at my 401 (k) administrator, I learned that I can make after-tax contributions, which can be converted to Roth. I already plan to max-out my 401 (k) with pre-tax money, which provides me with an instant tax break. I also receive an even larger tax break in my investment through my Health Savings Account. Any after-tax money I manage to put away will be converted to Roth on a few occasions throughout the year. This means that under current legislation, any earnings derived from that money will never be taxable. I would not be opposed if a larger portion of my net worth is held through tax-deferred assets, and therefore any dividends and capital gains would be deferred.


The total I can contribute to a 401 (k) in 2016 is $53,000. This includes my pre-tax contributions which are limited to $18,000, my employer match and any after-tax contributions I make. The sum of the three items listed above cannot exceed $53,000 for 2016 for individuals who less than 50 years old. Since I don’t earn a lot, and since I will have to pay some taxes on income, I may not be able to hit that whole amount. Yet, it may be worth trying. Paying taxes on dividends and capital gains is a drag in the accumulation phase, which slows down the process of accumulating that very same nest egg to live off in retirement.

The sad part about all of this is that I won’t be able to put much new money to work in dividend paying stocks. I will be reinvesting dividends in tax-deferred accounts and mostly spending them in taxable accounts.

Since the 401 (k) money comes right out of my paycheck, I will be investing automatically twice per month. My 401 (k) is invested the following way ( which is due to options available to me and not a recommendation to you, since I have different objectives and goals and experience than you).

60% Large Cap Index Fund (S&P 500)

20% Small/Midcap Index Fund ( Russell 2000)

20% International Stock Index Fund (EAFE)

Over the long-term, a portfolio of index funds will likely generate similar results as a diversified portfolio of dividend growth stocks. If you add in the tax advantage however, you can see that investing in mutual funds makes a slightly better sense today. The other advantage of 401 (k) plans is that they are protected from all forms of creditor judgment, whether it's the result of, say, a bankruptcy or a personal-injury lawsuit. This is an appealing feature, which provides a level of protection that taxable accounts do not.

I believe that this move will be beneficial in the long-term for me. This is because I will be able to Rothify a large portion of my portfolio, and ultimately will have much less in tax liabilities than investing in individual companies through a taxable account. In addition, having money in a tax-deferred account is helpful in eliminating tax waste during the accumulation phase. As I said before, I may continue doing what I am doing now even after I hit the dividend crossover point in 2018. Therefore it makes sense to keep most of my assets in tax-deferred accounts.

Once I do decide to retire however, I will convert those mutual funds into a diversified portfolio of dividend growth stocks. I still believe in the dividend growth stock strategy as a way for a retired person to live off their assets. We all know that dividend income is more stable than capital gains, which is evident when the stock markets around the world are crashing. For now, most of my assets are in dividend growth stocks. As I invest most of my money in a 401 (k) however, I will likely end up owning more assets there than through individual investments. Under current legislation, this will also provide tax benefits on investment income to those family members that inherit the assets as well.

I still have a lot to say about dividend growth investing on this blog. I like to analyze companies I own or would like to own in the future, and also think about different ways to utilize my capital for its best use. I also think about different ways to improve my finances all the time.

For example, when I invest in my Roth IRA in 2016, and potentially SEP IRA in 2016, I will be able to buy shares in individual dividend growth stocks. I am seeing a lot of companies where I want to build out my positions selling at better entry valuations than before. I am interested in more 3M (MMM), Accenture (ACN), United Technologoes (UTX), Exxon Mobil (XOM), ACE Ltd (ACE), Hershey (HSY), McCormick (MKC), General Mills (GIS) etc.

Full Disclosure: Long all stocks listed above

Relevant Articles:

Taxable versus Tax-Deferred Accounts for Dividend Investors
My Goals for 2016
Should taxes guide your investment decisions?
Dividends Provide a Tax-Efficient Form of Income
My Retirement Strategy for Tax-Free Income

44 comments:

  1. Hi DGI,

    What can I say? I'm just really jealous on you! You really deserve this and I hope you'll achieve your 2016 goal. This blog and the one from the conservative income investor really stand out when it comes to factual content, both i visit on a daily basis. So even if you can't invest a lot in dividend paying stocks in 2016, please keep on sharing the knowledge. You inspire a lot of people and you've made me smarter last year, that's for sure! Once again, thank you VERY MUCH :-) Sharing is caring and one day i'll hope to give back!

    ReplyDelete
  2. DGI,
    Very ambitious plan!
    Best wishes,
    KeithX

    ReplyDelete
    Replies
    1. I know, it's very ambitious. But I am setting myself up for failure on purpose - even if I "fail", I would still be better off than before per my spreadsheets.

      Delete
  3. Good plan, DGI, thanks for sharing.

    Avoiding or deferring taxes on your contributions now may not increase your dividends but it probably gives you an immediate 15-20% return on tax avoidance.

    SAK

    ReplyDelete
    Replies
    1. Yep, that's exactly what I had in mind. I am also trying to hedge myself against future tax rate hikes.

      Delete
  4. Interesting thoughts. How did you calculate 53,000 for 401k/Roth/HSA contributions?
    I thought the number would be closer to 30k. Can you clarify this please?

    ReplyDelete
    Replies
    1. Could you read the article again please, and follow the relevant links?

      I am asking you that, in order to teach you the importance of learning to do your own research.

      Delete
  5. I am curious, how did you figure out if your 401k plan can take after tax contributions up to $53,000? I was curious if you could please do an article on what type of questions to ask to figure this out. I asked my employer if this was possible from your article last year but I honestly don't think they even understand the rules. Currently I am contributing $55,000 between my 401k($18,000),RothIRA ($5,500x2) and the rest through normal brokerage accounts so figuring how to accomplish this would be huge in tax savings. On top of this I can invest in whatever I want through my 401k. Im not limited to only mutual funds.

    ReplyDelete
    Replies
    1. I called the 401K administrator several times.

      Each rep told me a different story. It could have been because I didn't use the correct terminology - when I explained what I am trying to do, they were more helpful. I got a rep that could do it. And then I got another rep that could do it. It could also be that Summary Plan Descriptions are written in legalese, so it is tough to determine what can or cannot be done on the rep's end.

      Each 401k plan has different stipulations on what it can or cannot do. Some allow incoming rollovers, others might not. Some allow brokerage link ( buying individual stocks rather than funds) , mine and others don't.

      I would think that you may want to call your 401K plan administrator, and ask them if you could either: convert after-tax money contributed to 401k into Roth within the 401K or alternatively outside the 401K plan into a Roth IRA.

      Delete
    2. so this is the response I got last year when I inquired about it:

      “The problem is that (plan administrator) is not set up to admin it. So, even if we(my employer) were to create amendments to allow after-tax contributions to the Plan, they cannot administer in-plan Roth conversions for amounts otherwise non-distributable. Which means that although you could save after-tax money above the limit, you could not convert it to Roth until you terminated, and at that point it would just be contributions that could be converted, you’d have to pay taxes on the gain, which defeats the purpose of what you’re trying to do.”

      I'm going to inquire with HR again soon to see if there has been any developments.

      Delete
    3. I'm not sure how it works, but when I left my job last year I was able to rollover my Roth 401k and after-tax additions into a new Roth IRA. I had no tax consequences on the after-tax additions (principal and gains). I assume this is because the money was already taxed.

      Delete
    4. Rolling over Roth 401k to Roth IRA is pretty standard though and has nothing to do with contributing post-tax money to a 401k, beyond the 18k limit, and converting that extra to a Roth. Only some plans allow these post-tax contributions.

      Delete
  6. Beware the pro rata rule when doing the Roth conversion...

    ReplyDelete
    Replies
    1. I am converting after-tax to Roth. Wouldn't the pro-rata apply if I were converting pre-tax IRA to Roth?

      Delete
    2. Ah, yes, I read too quickly. That is an IRA not 401k rule.

      Delete
  7. Thanks for adding this DGI. I like your strategy and it is something for me to think about. Thank you for getting the wheels turning and continuing to post useful information even though you aren't maxing out DGI stocks anymore.

    60% Large Cap Index Fund (S&P 500)

    20% Small/Midcap Index Fund ( Russell 2000)

    20% International Stock Index Fund (EAFE)

    ReplyDelete
    Replies
    1. No worries. I will be spending taxable dividends and reinvesting tax deferred dividends. PRetty sweet.

      In a few years, I may add some bonds to the 401 (k) too.

      Delete
  8. In reference to the stocks you are interested in at the moment, I was also looking at Hershey's this morning as well. Very compelling value. Have you ever looked into Tootsie Roll Industries? This one seems intriguing as well.

    ReplyDelete
    Replies
    1. TR is a great company, but it has always been too rich for my taste

      Delete
  9. D, I am so happy for you to be able to get to this point.
    You are a real example. Embedded in this line here is a lot of history: " The shortfall could be covered by any side income activities I engage in."
    In my perception this line is very underrated. You have acted like the companies you aspire to own and benefit from in that you posted consistently on your blog for the past 7+ years, three times a week every single week except for holidays. That kind of consistency is an amazing example of work ethic. Even if you put yourself down for "being on auto-pilot" and having pre-written posts, to have written them takes discipline, to input them into your blog, etc it's all work.
    You deserve all of your success and you have earned it. I think your consistency will continue to pay off as long as GOOG continues to participate in the monetization process. You have earned a following that respects the hell out of you, and with your consistency and "kaizen", you can do no wrong in my book. Congratulations on your semi-retirement experiment, what an empowering feeling. I know because I am just slightly under where you are. Almost there in similar ways.
    Thanks for all that you have done in sharing your journey, I have benefited immensely. I look forward to reading more of your philosophies and ideas.
    J

    ReplyDelete
    Replies
    1. Thanks J. Actually, I think that I am not that bright, or that good of an investor. But I am a very good saver, and have invested consistently over the years.

      I think that generating a side income opportunity is very valuable, because it turbocharges your savings potential. And if you can diversify that side opportunity, you are even better off.

      Take Care J!

      Delete
  10. Good plan. If you're planning to contribute to Roth 401k why not put that money towards a Roth IRA? Greater flexibility and allow you to continue DGI.

    If you're making over the Roth limit, then consider a backdoor, but need to transfer out any tIRA if you can.

    Do you have a solo 401k for your side biz? Fidelity solo 401k lets you buy stocks so in my opinion it's more advantageous to max out a solo401k then a company 401k. Money is fungible.

    ReplyDelete
    Replies
    1. I do the pre-tax 401 (k) to save on taxes. I expect to be in a lower tax bracket when I retire.

      As I mentioned above, I do expect to do regular Roth IRA.

      I think that an employer 401K offers more "protection" than a solo 401k in some instances, which is why I am doing that. However, I also have a SEP IRA, which allows more to be deferred overall.

      Delete
  11. Hey DGI,

    Looks like you've taken your time and figured it all out in great detail. Living off your dividend income this year will definitely be great preparation for the future.

    I wish you the best of luck,
    DB

    ReplyDelete
    Replies
    1. Yes, that will be a good preparation ( a dry run) to see how I feel

      Delete
  12. Great plan and will be paying close attention to your moves when it comes to dividend and index investing.

    ReplyDelete
    Replies
    1. Funny part is that S&P 500 has increased dividends each year since the bottom in 2008. There is a lot of overlap between great dividend growth stocks we follow and stocks in the major stock indexes ( or Nestle in EAFE)

      Delete
  13. Hope you hit or come close to your 2016 goals! Thank you for sharing all your knowledge as it has helped inspire me to start to begin turning the ship around at the age of 30!

    Cheers!

    ReplyDelete
    Replies
    1. Travis,

      I am glad you have taken a hold of your finances, and you are working towards achieving your long-term financial goals!

      DGI

      Delete
  14. would also enjoy reading details on monthly expenses, adjustments, + surprises, potential shortfalls etc on your 2016 personal expense planning/execution.

    nice work- you have a lot of quiet followers

    ReplyDelete
  15. Congrats on living the dividend dream and banking the paycheck. I have followed your blog for many years and has helped me with the discipline to save, invest and DRIP my dividends.
    As a result, I am retiring early (59) and moving to Mexico. My 12 mth fwd taxable dividend stream is ~US$2,400 @ mth which at US$1.00 = MXN$18 pesos will live a life of luxury. Helps defer social security until well into 60's.
    My 401k, IRA & Roth will sit with slightly riskier DGI stocks until the day I need distributions.
    I wrote a dividend tracking spreadsheet in Google Docs and using googlefinace finance can see my real time finance numbers. Another very helpful tool was a long term monthly average spending spreadsheet to track your expenses so you never exceed your dividend stream. Special thanks to Billy and Akaisha Kaderli at www.retireearlylifestyle.com for that one.
    I look forward to your 2016 experience with your plan. Best regards, Craig

    ReplyDelete
    Replies
    1. Congrats on reaching your retirement goals! $2,400 in dividend income + SS, means you will likely live a great lifestyle.

      Mexico sounds like an interesting place to retire - there is an expat community, COL is lower, and it is close to the US too.

      You may also read about the Charlton's too..http://wherewebe.com/

      Discipline is tough, which is why I will try to automate my investing through 401K and automatic dividend reinvesting ( and spending the taxable dividends). I also feel uneasy about the stock market, which is why automating could be the best course of action for me, rather than second guess myself all the time.

      I would be careful about riskier stocks. On days like today, I am happy to be owning a lot of consumer staples.





      Delete
  16. Holy smoke! That is gonzo ambitious. My spending seems to be about the same level as yours and I can happily report it isn't a bad life. I don't want for anything important.

    Sounds like you might be pulling the plug soon? If can prove to yourself you can make it without the paycheck, why have the paycheck? Here's hoping there are good Obamacare options in your state!

    ReplyDelete
    Replies
    1. Since I don’t make a lot, and since I will have to pay some taxes on income, I will not be able to hit that whole amount. This also assumes they keep me.

      But I want to see how I hold up when I live off only dividends and other income. I think psychologically, it would be difficult to spend my whole income and not be able to save in FI. So when I automatically put money in 401K, it would feel as if I am not saving ( since I cannot touch the money to buy a latte for example without going through some hassle)

      I am thinking of staying put a little past the dividend crossover point in 2018. I want to build out my fixed income holdings as an insurance, plus I enjoy my gig.

      Hopefully the next president doesn't repeal the ACA. But otherwise, I think that healthcare is more affordable.

      Delete
    2. Healthcare is more affordable abroad is what I meant ;-)

      Delete
  17. DGI

    Will you lose the ability to claim foreign tax credits on the 20% of the 401K you are allocating to an international stock fund, since you won't get a 1099 listing out the foreign taxes paid? If so, that would seem like a tough one to absorb.

    Congratulations on your progress

    ReplyDelete
    Replies
    1. I won't be getting ability to claim foreign tax credits.



      Delete
  18. Yes, you cannot claim a foreign tax credit for foreign taxes that are withheld in a retirement account.

    ReplyDelete
  19. Given the start of 2016, would you not reconsider delaying your plan?
    This should be a year, or first half of a year, to pick many cheap stocks and would be a better use of your dividend income.

    Anyways, congrats.

    ReplyDelete
    Replies
    1. Well, if I don't put the money in through the paycheck for the 401K, I miss out on the ability to contribute. And I think that this might be a limited opportunity. But I think that buying a basket of dividend growth stocks will likely produce a similar results as a basket of mutual funds.

      Now, if I were good at timing markets, I could accumulate fixed income funds rather than stock funds, and only buy when the prices have bottomed. But I am not ;-(

      Delete
  20. Excellent goal DGI. Looking forward to updates on how you live off of just divs.
    Later,
    DFG

    ReplyDelete
  21. Given the turnaround in the stock market, I am going to be adding a Total Bond Fund/Stable Value Fund mix to the mix. This will likely skew the contributions to 80% stocks/20% fixed income.

    ReplyDelete

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