Friday, October 21, 2016

How to Grow Dividend Income Much Faster With Tax Advantaged Accounts

When I was doing my taxes for 2012, I realized that tax expenses were larger than my living expenses. I realized that in order to correct this, I need to legally minimize as much of taxes today as possible. I achieved that by maxing out all tax deferred accounts within my reach.

Since my epiphany in 2013 on the benefits of tax-deferred accounts, I have plowed most of my dollars into my 401 (k), Heatlh Savings Account (HSA), Roth IRA and SEP IRAs. I have noticed that since those moves, my dividend income and net worth increased much faster than before. This was not simply due to the bull market we experienced. It was because I just dutifully put money to work every two weeks or so, and let it sit there without touching it. In addition, the tax incentives really increased my net dividend income, and the amount I have to reinvest back.

For example, assume that all I can invest is $21,000/year. If I invested that in dividend stocks yielding 3%, I would generate $630 in annual dividend income. The types of dividend growth stocks that could make up this portfolio could include the likes of:

Johnson & Johnson (JNJ)
Target (TGT)
T.Rowe Price (TROW)
V.F. Corporation (VFC)
Altria Group (MO)
PepsiCo (PEP)
Wal-Mart (WMT)
Verizon (VZ)

I would then pay 15% to the friendly federal government and approximately 5% to my business friendly state/city governments. This leaves me with roughly $504 of dividend income to reinvest, save or spend.

Let’s see how the math works if I put the money in my 401 (k) and H S A. Let’s assume that I can put $18,000 in my pre-tax 401 (k) and $3,000 in my H S A account. Given the lack of options there, the money will be invested in S&P 500 (or a Total Stock Market Index), which yield roughly 2% today. As a matter of fact, the companies in the S&P 500 index are on par to raise its annual dividends for 7 years in a row by the end of 2016. Over the past 56 years, dividends on S&P 500 decreased in only 7 of those years. Most of those declines were minimal in the 1% - 3% range. The only large decline was in 2009, when dividends fell by 20.50%. This is why we believe that dividends are more stable than capital gains, and since their amount and timing is easier to predict, dividends are more reliable than capital gains.

By maxing out the 401 (k) & HSA, and investing in an index fund, those accounts will generate $420 in annual dividend income. Since taxes are deferred for decades, until I need that money, I get $420 in dividend income. When I need the money, I will access those accounts in manner where they would not result in a lot of taxes ( Roth Conversion Ladder). Plus, I plan to retire to a state with no income tax.

By contributing to retirement and medical accounts however, I get to defer taxes as well. For every dollar I get to contribute to my pre-tax 401 (k), I avoid paying 25% in Federal Taxes and 5% in State/Local Taxes. Therefore, if I contribute $18,000 to my 401 (k), I end up saving $5,400 in taxes. This means I now have $5,400 more to potentially contribute towards investing for my future. Since I end up with more shares that generate more dividend income in total, using the same amount of starting cash, it is as if I am in effect purchasing stocks at a 25% discount. In my case, I would just max out my Roth IRA account at $5,500/year into another fund like S&P 500 yielding 2% ( the extra $100 comes from the H S A below). This increases my net dividend income by another $110/year. This brings the total dividend income to $530/year. The best part is that with a Roth IRA, I will not have to pay any taxes on earnings, as long as I withdraw them after the age of 59 and 1/2 . I can withdraw principal at any time, without penalties or taxes.

But that is not everything of course. When I contribute $3,000 to my H S A, I avoid paying 25% in Federal Taxes and 5% in State/Local Taxes. In addition to that, I also avoid paying 7.65% to the nice people over there at FICA. This is a total of 37.65% in taxes I get to defer. This comes out to a savings of $1129. I will put the first $100 towards my Roth IRA above ( astute readers would have noticed that I got a tax benefit of $5,400 but contributed $5,500 to the Roth IRA for a deficit of $100).

I can then put an additional $350 towards my H S A, since the limit is $3,350 for a single person ( though it is $6,750 for a couple). This results in additional tax savings of 37.65% on the $350, for a total of $132. If I invest those $3,350 in an S&P 500 index fund yielding 2% today, I would increase my dividend income by $67/year. The nicest thing is that now my total annual dividend income increases to $537/year. But wait, there is more.

All of this tax maneuvering leaves me with $811 to invest through a taxable brokerage account. I get to this number by:

1) Adding the tax benefit of $1129 for putting $3,000 in my H S A
2) Contributing an additional $350 towards my H S A
3) Adding the tax benefit of $132 for putting in an additional $350 to my H S A
4) Removing $100 that I used to max out the Roth IRA above

If I invest those $811 at 2%, I will manage to increase my dividend income by $16. Of course, if I pay 20% tax on that, this leaves me with $13 in additional dividend income. This increases my dividend income to $550/year.

I got to this number by:

1) Adding the dividend income from the 401 (k) account of $360/year ($18,000 times 2%)
2) Adding the dividend income from the H S A of $67/year ($3,350 times 2%)
3) Adding the dividend income from the Roth IRA of $110/year ($5,500 times 2%)
4) Adding the dividend income from the taxable account of $13/year ($811 times 2%, minus 20%)

All of this leaves me with $550 in annual dividend income, using investments that yield 2%. The taxable dividend account that was invested at 3% ended up generating $420 in net dividend income. So in essence, I ended up with roughly 30% more income using tax-deferred accounts such as 401 (k), H S A, Roth IRA. Tax advantaged accounts won out, despite using investments with lower yields today.

Now imagine if those assets were invested at yields of 3%.

Full Disclosure:

Relevant Articles:

How early retirees can withdraw money from tax-deferred accounts
Taxable versus Tax-Deferred Accounts for Dividend Investing
How to buy dividend paying stocks at a 25% discount
Health Savings Account (HSA) for Dividend Investors
Should taxes guide your investment decisions?

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