This post is long overdue, but better late than never. Over the last couple years I’ve answered many questions regarding the status of my equity holdings and whether or not these holdings are in a tax-advantaged account (like an Individual Retirement Account) or in a taxable brokerage account. I hold 100% of my equity investments in a taxable account and I’m going to explain why in this article. Before I get started, however, I’d like to point out that this is one of those very rare occasions where I’d prefer you do not as I do. For almost everyone out there I’d highly recommend maxing out the tax-advantaged accounts you have available to you (401(k), IRA, Roth IRA, etc.). With this article I hope to accomplish a couple things. First, I’d like to have a one-stop resource for anyone who has questions as to the status of my tax exposure, and secondly also provide some insight for any who are considering a similar strategy.
My employer doesn’t offer a 401(k) match.
If my employer offered a match on the funds I contributed towards a work-sponsored 401(k) retirement account I would likely take advantage of that, as this is essentially “free” money. It’s a guaranteed return on my investment, up to the match. However, my employer doesn’t offer a match. Furthermore, the funds they offer are poor in choice and high in fees. Due to this, I have opted out of investing in any of these funds choosing instead to focus on my Freedom Fund.
This is where my situation is extremely unique, and why I don’t recommend you necessarily follow in my footsteps here. I’m likely going to be accessing the passive income my portfolio throws off by the time I turn 40. That’s less than nine years from now. What I’m looking to do is to maximize my chances of retiring early off the dividend income my portfolio can provide, and as such I need to throw every free dollar I have in high quality investments that will provide accessible and liquid passive income in less than a decade. If I were to deviate from the taxable account and start concentrating on an IRA and/or Roth IRA I would have less free cash flow with which to invest in the portfolio that’s actually going to be sustaining me once I’m no longer working full-time.
Furthermore, my investment horizon is rather short. This doesn’t give the tax-advantaged account(s) the full access to the power of tax-free compounding over many decades that investors who otherwise choose to work a traditional 30-40 year career will have. Say I wanted to open a Roth IRA tomorrow. I’d have nine years to contribute the maximum, currently at $5,500 per year. That’s $49,500 that I’d be contributing towards a tax-advantaged account. Certainly not chump change, but just not the kind of capital that is going to make a big difference over the next nine years in terms of tax savings. However, if I instead continue to funnel those funds into my taxable account that’s $1,750 more per year in annual dividend income that I’ll have access to (at a 3.5% yield) if calculated as a lump sum. That income will likely be higher because it’ll be invested over the course of almost ten years. On the absolute low end, that’s an additional $145 in monthly income. For someone who plans to become financially independent on a frugal budget, that makes a big difference for me.
Dividends are tax-efficient all by themselves.
This is something that is rarely discussed, but an important part of my strategy. Currently, if you’re in the 0% or 15% marginal income tax rates here in the U.S. you’ll pay 0% in taxes on qualified dividends. That’s right. 0%, folks. That means even if I have my portfolio exposed to the full force and power of the IRS’s taxing ability, I’ll still pay 0%, or close to 0%, on my dividend income assuming I meet certain income criteria.
Qualified dividends are normally dividends from paid by a U.S. corporation or a foreign corporation that trades readily on a U.S. exchange (such as ADR shares), while also have meeting certain holding periods. REIT dividend income, for instance, is not considered qualified dividend income.
Currently, in order to cross the 25% marginal income tax bracket you’ll have to earn $36,251 per year. That means as long as I earn under $36,251 per year in qualified dividend income I’ll pay 0%. Now, this is in theory and not reality as I already have some exposure to real estate investment trusts, and the dividends they pay will be taxed as ordinary income. However, my overall income will still be so low that I’ll pay very little in income tax when all is said and done.
I’m currently planning on becoming financially independent by 40 years old so that I can quit the rat race and focus on my passions. As such, I’m not going to have a seven-figure portfolio that I’ll be drawing income from. As it stands, I’m forecasting somewhere around $18,000 in dividend income by the time I’m 40 based on where I’m at right now and the progress I’ve made thus far. That means it’ll likely be many years before I cross that $36,251 threshold to the 25% marginal income tax rate. Even then, qualified dividends are only taxed at 15% (the same as long-term capital gains). Of course, it’s impossible to forecast tax rates and rules over any kind of time period, let alone a decade from now. However, I think it’s safe to say that this tax bracket won’t be lowered significantly.
My exposure to taxes on dividends will be limited.
Again, I have about nine years or so to go before I’m living off my dividend income. Hopefully, it’s an even shorter journey than that. Due to this, the overall time that I’ll be exposed to taxes on my dividends will be the same. So if I live a life equal to the U.S. life expectancy of 76 years, I’ll have about 12 years of exposure to taxes on my dividend income (based on my journey) and about 30 years of non-exposure (from 40 years old on).
Furthermore, and more importantly, the amount of dividends I’ll be receiving as I ramp the passive income up and get closer to living off of it will be much smaller than the amount I’ll actually be receiving once I’m living off of them. One of my goals is to receive $3,500 in dividend income during the calender year of 2013, which I’m on pace for right now. Since I’m over the 25% bracket for some of my income right now, I’ll be exposed to 15% taxes on my qualified dividends. That adds up to about $525.00, factoring out the very little REIT dividend income I’ll be receiving this year. Again, not chump change but I’m looking at the long-term. My dividends will likely increase on the order of $1,200-$1,500 per year until I turn 40. So by the time I’m receiving serious dividend income in the range of $1,000 or more per month I’ll be close to living off of it. And then I’ll be dropping full-time work and hence my income will significantly drop, meaning my tax bracket falls and I’ll be exposed to very little in dividend taxation. Plus, I live in a state (Florida) that does not tax dividend income.
Taking income from a qualified retirement plan before the normal withdrawal age is difficult.
It is possible to withdraw funds from a qualified retirement account like an IRA or Roth IRA before 59.5 years old, however these strategies appear to be a lot easier on paper than in reality. For instance, you can invoke rule 72(t), also known as Substantially Equal Periodic Payment (SEPP), to withdraw funds from a qualified retirement account without having to pay early distribution penalties. However, these withdrawals are still subject to ordinary income tax. Another way to access qualified retirement account funds early is withdrawing Roth IRA contributions. You can withdraw contributions from a Roth IRA at any time penalty-free. But it’d be hard to rely on this solely, as you could quickly start to withdraw more than you contributed. And the amount that one could possibly invest in a Roth probably wouldn’t be enough to significantly impact their early retirement plans.
Now, if you’re the type of person who likes to deal with the IRS more than you have to, then a SEPP would probably be right up your alley. If you’re also the type of person who likes to keep extremely accurate records, more paperwork than otherwise necessary and also keep up with your amortization methods, life expectancies and changes in rules that the IRS may publish at any time then the SEPP would probably be the way to go. However, for all intents and purposes I’d prefer not to expose myself to the bureaucracy a plan like this involves, especially when, as discussed above, we’re talking about ~$50,000 in contributions. And although the SEPP is a method you can use to access funds from a qualified retirement account without paying early distribution penalties, this rule could be changed in the future. I’d rather not hinge my early retirement plans on IRS rules like this.
Although I don’t plan on using tax-advantaged account, that doesn’t mean you shouldn’t either.
I’m on a path that is rather unique. Most people out there don’t share my passion to retire from full-time work so early in life, and there are even fewer who are interested in being as aggressive or extreme as I am. Because of this, I highly recommend tax-advantaged accounts where possible for anyone who has access to them. However, if you do choose to open a Roth IRA, IRA or 401(k) my recommendation is to let those funds compound tax-free until you’re old enough to withdraw them without extra encumberment. The best thing to do would be to save and invest enough to where you could simultaneously fund a taxable account and a tax-advantaged account(s) so that you can retire early and live off the taxable account’s funds until you’re old enough to start withdrawing from the tax-advantaged account(s). Think of this like a rocket. You’ll get the initial explosive momentum to the stratosphere from your taxable account funds, and then that extra boost from the tax-advantaged account(s) to get you into outer space in your older years.
However, this all being said if you do really share a passion for becoming financially independent as soon as humanly possible I would recommend eschewing tax-advantaged accounts to focus solely on a taxable account. This way you focus 100% of your available resources on maximizing your potential for building passive income. This could be done via investing in high quality dividend-paying companies like I do, or investing in real estate or even investing in index funds. If you make a middle class income and truly want to become financially free at a very early age (40 or younger) then I believe you’d be best served putting everything you’ve got behind investing in an account that will be accessible to you whether or not the IRA changes tax-advantaged account rules or not. Besides, for every year you can avoid working and instead focus on your passions you’ll be avoiding a lot of taxes on your income anyhow.
For me, it would make no sense to try and simultaneously build a taxable account and tax-advantaged account if it meant I’d have to work for another year or two and face continued taxes on both my earned income via full-time employment and those dividends the taxable account are supplying.
How about you? Focusing on your taxable account or tax-advantaged accounts? Or both?
Thanks for reading.
Photo Credit: Stuart Miles/FreeDigitalPhotos.net
Edit: Corrected Roth capitalization.