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Introducing The Dividend Well

I was born and raised in the country. The only source of water we had for both drinking and washing was from a well. This was true for not only our family but also for those that lived near us. It stayed that way until I left home at 18 years of age to enlist in the military. Unfortunately, our machine-dug well would often run dry. If my mother washed a couple loads of clothes and each of the family members took a bath, we would have to wait for the well to refill before we had more water. My father finally decided we needed an additional well. We couldn't afford to have one dug, and so one summer my father, my brother and I hand-dug a well. It was a lot of hard work, mostly pick and shovel with a little dynamite, and there were a number of memorable experiences in the digging of it, but the end result was we hit water and that well to this day has never run dry.

It may sound strange, but I find many similarities to us digging that well and my dividend growth investing. Just as we added a second well to supplement the first, many investors utilize dividend investing to supplement their retirement income, or in many instances, to be the primary source for their retirement income. If one is going to be dependent upon that dividend income, then it behooves the investor to have a plan in place to make sure that the dividend well doesn't run dry. Because of one's particular circumstances, it's possible to get to a point where income isn't flowing as well as one would like. So how does one ensure that the income stream keeps flowing?

For purposes of this article, I am assuming the use of three basic account types for self-directed investment accounts. I realize there are a number of different types and variations, but the three I'm referring to are the traditional IRA, the Roth IRA, and the regular (taxable) investment account.

Rules Of The Well

In the taxable account, funds can be added at any time, limited only to one's ability to fund it, taxes on the realized short-term and long-term capital gains have to be paid annually, losses written off or carried forward, taxes paid on dividends and interest received on the account, and funds removed whenever desired. Both the traditional IRA and Roth IRA are limited as to the amounts that can be added annually. The traditional IRA allows contributions to be deducted from taxes (subject to eligibility/limits), whereas the Roth IRA doesn't. Required Minimum Distributions, or RMDs, require funds to start being removed from the traditional IRA account by April 1 the year after the year you turn 70 1/2 years old, and then by December 31 thereafter. This link provides a worksheet for calculating the minimum distributions. The Roth account doesn't require minimum distributions during the owner's life and when funds are received, no taxes are due under current tax laws.

In 2013, the maximum you can contribute to either IRA type is the smaller of $5,500 ($6,500 if you're age 50 or older), or your taxable compensation for the year (excluding rollovers). But the IRS never makes anything that simple, so there are other limitations to consider for both accounts. The $5,500/$6,500 contribution limit is a total for both accounts so if, for example, you're age 50, have both traditional and Roth IRA accounts and you contribute $2,000 to the traditional IRA, you are then limited to $4,500 for the Roth IRA. But there are also modified adjusted growth income limits affecting the amounts that can be contributed as well, such as to Roth accounts, so one should consult their CPA, tax attorney, or other qualified entity to make sure they meet the requirements.

There are also limitations on the type of income, commonly referred to as qualified income, which refers to the type of compensation. For example, it includes wages and salaries, commissions, alimony, and self-employment income, but doesn't include earnings and profits from property such as rental income, dividend or interest income, and it also does not include pension or annuity income.

I’ll use my personal situation as an example. We have a traditional IRA, a Roth IRA, and a taxable account. Since we’re both over age 50 our maximum contribution for 2013 is $6,500. But I’m retired and receive a pension so that pension income cannot be used to make contributions. I haven’t started drawing social security but if I did then that could not be used either. If the pension or social security were our only sources of income then we would not be able to make any additional contributions to our IRA’s. It doesn’t matter that I may have plenty of money available to contribute it still has to be qualified income in that contribution year. However, I still do some occasional consulting work and my wife still works part time, so we can use that income to meet the qualified income requirements for contributions.

I still have to monitor the qualified income to make sure that it exceeds the amount that I contribute. If, for example, in January 2013 I contributed $6,500 to my Roth, but both my wife and I failed to work as much as we anticipated and at year's end we had only $4,500 of qualified income for that year, we would be facing an excess contribution occurrence. That means it would be taxed at 6% per year as long as the excess amounts remained in the IRA. To correct it, I would need to withdraw the excess contributions by April 15, 2014 (unless extended), and also withdraw any income earned on the excess contributions. These withdrawals of excess contributions also have the potential of impacting my gross income for tax purposes. If I made well over $6,500 in qualified income and still wanted to contribute, it would have to be in my taxable account once I maxed out the IRA accounts.

$5,500 or $6,500 may not seem like all that much to contribute on an annual basis from outside the account when compared to a six figure salary or 6 or 7 figure account, but in reality, it can be significant. It's 10% set aside to be invested by an individual having $55,000 in annual income, or about $450 per month saved and invested. Conversely, it won't buy 100 shares of McDonalds (MCD), but it can be used to add to or establish initial positions. But once the contribution limit is met, that's it for outside additions to the IRA account. It has to then be increased from inside the account. There are multiple ways to do this, with the intent of all of them being to generate cash that can be used to add to the account. The following methods I use are listed in no particular order of importance.

(click to enlarge)Dividend Well

Keeping The Water Flowing

The first way is to sell certain positions when they are over-valued. Modern portfolio theory says that selling positions, or partial positions, is the way to generate income for retirement. I prefer a different approach, which is to use dividends to generate income for retirement. That way, I keep my shares and still get income. Typically when I sell a position, it's for one of three reasons: it has become over-valued and it's time to take profits and use the proceeds to invest in other positions; the fundamentals of the company have changed, and I no longer want to own the company; I've identified better uses for the funds tied up in a particular company. There are different methods to determine if a company has become over-valued. Here are three quick and easy ways: 1 - keep an eye on the dividend yield; if the yield shrinks to a point where it's historically low (to where you would no longer buy it), it's possibly over-valued. The dividend investor who bought MCD in early 2009 at a yield of 3.75% had three years later seen the yield shrink to 2.75% and had a price gain of over 80%, not counting dividends received. 2 - Check the Morningstar star rating. If they have analysts who cover a given stock, they assign stars based on the market price relative to their estimate of the fair value and the expected return. 1 or 2 stars means a lower return is expected, so it could be considered over-valued; 3 is fairly valued; and 4 or 5 means a higher return is expected, so it could be considered under-valued. 3 - Use Fast Graphs to check value. As you can see in the chart below, MCD dipped below the orange fair value line in 2009 and moved well above it in 2012.

(click to enlarge)MCD Fast Graph

Neither of these, of course, should be considered automatic decision makers. The astute investor should always validate any approach and do their due diligence before making a final decision to buy or sell. In other words, make sure a position meets your plan and rules for your portfolio before you buy or sell. And to be clear, I don't consider selling every position in my portfolio when it gets over-valued. There are some core positions that I simply hold and collect dividends. Then there are other positions that I use to move in and out of while collecting dividends in the meantime. In my opinion, unrealized gains can be ephemeral and with a portion of my portfolio, I want to take advantage of the market over-pricing and realize those gains.

Dividend management is another way to increase the water flow in the well. I'm including distributions in this for sake of discussion to reflect possible income received from MLPs, BDCs, and CEFs. One can obviously select different investment types to generate cash coming in to the accounts, including bonds or bond funds. The debate between bonds and stock equities could take multiple articles and still not resolve the debate. Bonds have their place, and I don't intend to demean them. Suffice it to say for my purposes here that I prefer dividends that are increasing greater than the rate of inflation. In essence, there are only four things that can be done with dividends: withdraw from the account and use them; let them sit there and draw minimum interest, DRIP them; accumulate them and reinvest into shares of the same or other companies in order for the dividends to compound. Keep in mind compounding can only occur if they stay within the account. If they need to be withdrawn for living expenses, and they're meeting your needs, then congratulations, it's working. If just sitting there, it should only be for the time necessary to accumulate enough to make a worthwhile purchase. Otherwise, it's a waste of capital usage and an opportunity cost.

The most appropriate dividend management to me is to allow them to compound within the account, assuming I'm not withdrawing them for living expenses. That means either DRIP them or accumulate them. The advantage of dripping is that it automatically reinvests the dividends and dollar cost averages the dividends into additional shares. But that is also the disadvantage. You may be buying at an under-valued price, or you may be buying at an over-valued price. You don't control it -- the broker simply automatically buys at what the market price is when the dividends are reinvested (often at the close). This takes decision making out of the process if one simply wants it to be automatic. DRIP may be the most appropriate method for the small account if accumulation of substantial proceeds for new purchases would take a long time. That's a decision each investor must make for his own purposes.

Accumulating within the account can be a fixed amount, or it may be a percentage amount of a desired position size for a specific stock. Just be sure it's of sufficient size to minimize commission costs because over time, these can add up. Once the dividend proceeds are sizable enough for purchase, one can then select the best value stock for purchase that meets their individual requirements. This will eliminate the automatic purchase of a potentially over-valued stock. I have enough value investor in my DNA that I want to control when and at what price I buy. And combining accumulating dividends with adding additional funds to the account may provide the most efficient use of the available funds.

The last method I use to increase the "water flow" into the well is through the use of options. What I like about options is that they allow me to use other people's money to increase the income, or generate cash, for the account. Options can be complex, and they can be simple. They can be bought or sold monthly, quarterly or even one year or more out using "LEAPS", which is an acronym for Long term Equity Anticipation Securities, simply meaning their expiration is one year or longer away. Weekly options are even becoming popular now. Options can be used to create "synthetic" long or short positions, to hedge positions, and to take advantage of market directions and volatility. They can have cute descriptive names like butterflies and condors, straddle and strangles, verticals and calendars, and have a mathematical basis referred to as Greeks, but at their most basic level, they consist of calls and puts, and each option contract represents 100 shares of a stock. Buying an option gives me the right, but not the obligation, to buy or sell the 100 shares each option represents at a fixed price. However, and this is important, selling an option obligates me to either buy or sell the shares that each option represents. Options can be very profitable, but also very costly if not managed correctly.

I don't mean for the above paragraph to be an options primer, but some basics were in order to explain how I use options to increase the water in the well. Probably the most common type of options utilized by most dividend investors are the cash secured put and the covered call. I believe these two are efficient and practical tools for the dividend investor, but quite frankly, I also believe the typical dividend investor should stay away from other option methods, including using margin for them. I realize that's heresy to the normal option trader, but my reasoning is that the typical dividend investor is looking for long-term dependable growth and is an investor, not a trader or speculator, so keep to the basics. I made a personal choice to no longer spend the time trading options as I have in the past, and now only use these two methods and the occasional spread. My philosophy is that the dividend growth companies I invest in are typically low beta stocks, so I don't have the volatility most options traders try to take advantage of. That means I don't get the higher premiums, but I can still generate decent income on companies I want to own. With these two methods in mind, how can they be used to increase income?

Let's say I want to buy MCD and I want to buy a 100 share position, but I only want to buy it when the price moves down to or below $87.50. If it's not there yet, I can enter a good till cancelled limit order at $87.50 per share and wait for it to be filled. In doing so, I committed the capital to pay a total of $8,750 for those 100 shares. I can do the same thing using options by selling a cash-secured put. For example, I check the January expiration for the 87.50 strike put and the premium is $.26 or $26 for 100 shares (as of 1/2/2013). However, the February expiration premium is .88 or $88 for one month longer, or 44 days from when I calculated this. So I can sell the February 87.50 strike put and immediately collect the $88. If MCD is below 87.50 by the third Friday of February, then I get exercised and buy 100 shares at 87.50. My cost basis for the stock is then $86.62 per share (plus option costs). It could have also moved lower than $86.62, but it could have done that if I had just bought it outright at $87.50. If it doesn't move down to $87.50, then I simply keep the $88 cash in my account, less commission. Someone just paid me to have the right to sell me the stock at $87.50 but didn't get to. On an annualized basis, my income for those 44 days for my capital tied up is an 8% yield. That's on a company with a beta of .40. One word of caution is this: I suggest you never sell a cash-secured put on a stock you don't want to own.

Selling covered calls can be used to generate cash for use in acquiring other positions, to lower the cost basis of existing positions, or to exit positions. For example, I own Waste Management (WM) and wasn't exactly pleased with its latest 2.8% dividend increase. That's less than inflation, so I considered selling it immediately, but decided to sell a covered call instead. I sold the February 35 strike call. If on the third Friday of February it closes above $35, then my option will be exercised. I'll sell 100 shares at $35 and move on. If it's below $35, I keep the cash and I still own WM. I'll then consider repeating it, and select the strike price at that time. If WM announces a dividend record date that is before expiration, I still collect the 4%+ dividend yield. One could argue that WM could move significantly above $35 and I lose that profit. That's possible, but I didn't buy it as a growth stock and it's not my intent to hold it for a potential upward move. I bought it as a dividend stock and if it stops growing the dividend like I want, then I consider replacing it. I still have the ability to close the option and sell the stock at any time, or roll the option to another expiration period if so desired.

Options aren't for everyone, but they can be a valid tool to generate cash for the account. If you haven't used options, then you might want to consider them. But be sure to study first, consider using a practice account before using real money, and walk before you run. There is plenty of information about them easily accessible over the web. But again, stick to the basics. Also note your account has to be approved by your broker to use them.

Summary

In my situation if I max out my annual IRA contributions near the first of the year, then I want to use the tools I have at my disposal to keep cash coming in to the account so that it can be grown. All of the above examples -- selling over-valued positions, dividend management, and options -- are just that, tools that can be utilized if I so desire. They are all part of the toolbox in my portfolio management plan that I can select to use at different times to keep the water flowing into the well. I remember there was something special, something refreshing about drinking a dipper full of cold well water on a hot summer day. I also find it refreshing to keep the cash coming into the dividend well. Someone once said you don't miss water until the well runs dry. Here's hoping your dividend well holds plenty of water in 2013.

Source: Don't Let The Dividend Well Run Dry

Additional disclosure: I am not a professional investment advisor, just an individual handling his own account with his own money. You should do your own due diligence before investing your own funds.