Friday, November 1, 2013

Taxation and Investing

In the past week, I wrote a four part series about taxation matters for dividend investors. Check the original articles here:

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 IRA contributions 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.

Full Disclosure: None

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