Readers of my April Fool's post chuckled at my spending addiction; I mentioned how the tax man was preventing me from investing in stocks for almost two months. I recently opened an IRA and allocated the funds equally in the following six dividend stocks:
Chevron Corporation (CVX), through its subsidiaries, engages in petroleum, chemicals, mining, power generation, and energy operations worldwide. The company has raised dividends for 25 years in a row, and has a ten year dividend growth rate of 9.60%/year. Currently, this dividend achiever trades at 9 times earnings at yields 3%. Check my analysis of Chevron.
Philip Morris International Inc. (PM), through its subsidiaries, manufactures and sells cigarettes and other tobacco products. The company has raised dividends for 4 years in a row. Currently, the stock trades at 18.60 times earnings at yields 3.60%. Check my analysis of Philip Morris International.
Johnson & Johnson (JNJ), together with its subsidiaries, engages in the research and development, manufacture, and sale of various products in the healthcare field worldwide. The company has raised dividends for 50 years in a row, and has a ten year dividend growth rate of 11.70%/year. Currently, this dividend champion trades at 16.90 times earnings and yields 3%. Check my analysis of Johnson & Johnson.
McDonald's Corporation (MCD) franchises and operates McDonald's restaurants in the United States, Europe, the Asia/Pacific, the Middle East, Africa, Canada, and Latin America. The company has raised dividends for 36 years in a row, and has a ten year dividend growth rate of 28.40%/year. Currently, this dividend champion trades at 19.30 times earnings at yields 3%.
Kinder Morgan, Inc. (KMI) owns and operates energy transportation and storage assets in the United States and Canada. The company has raised dividends ever since it went public in 2011, yields 3.80%, and is projecting to grow dividends by over 10%/year for the foreseeable future.
Vodafone Group Plc (VOD) provides mobile telecommunication services worldwide. The company has raised dividends since 1989. Since 2002, the annual dividend in British Pounds has increased from 1.47 pence/share to 9.52 pence/share in 2012. Currently, this international dividend achiever yields around 5%.
The reason why I purchased these companies is because they were attractively valued at the moment, provided decent entry yields and the opportunity for growth in earnings and dividends going forward.
By making this IRA contribution, I was able to reduce my tax due by more than half. The amount I put in the IRA produced an instant tax savings that was equivalent to over one third of its value in taxes. This also made me review my paychecks closer, and I noticed that I pay in taxes an amount that could easily cover 60% of my expenses. This was the tipping point that made me think about reducing tax expenses in order to accumulate as much funds in my name, both in taxable and tax-deferred brokerage accounts. Most people do not even realize the amount of taxes they pay each year, because they are automatically withdrawn from their paychecks.
Long-term readers might have sensed the fact that I am a big fan of early retirement. According to my 2013 goals, I discussed how I would be able to retire in five to six years. As a result, I have always discussed that I keep most of my investable assets in taxable brokerage accounts. It made sense for me to only put the bare minimum in tax-deferred accounts, such as 401 (k), only to get the company-sponsored match. Since 2009, I have consistently ended up owing money to the government come April 15.
What I realized over the past year is that the taxes I end up paying do not provide a specific benefit to myself. These taxes help pay for roads, defense, education and public services, but the payment of them was costing me a lot of money. Just looking at my paychecks, I recently realized that I need to make a change. As a result, I am going to contribute the maximum I can in 401 plans and IRAs, in order to reduce my taxable income. Any tax savings from deferring my spending will be directly realizable to me, although there are a few obstacles to that.
The first issue is that there are limited investment options for 401 plans. For IRAs however, it is possible to put individual dividend paying stocks. As a portion of my total portfolio however, I do not foresee the sum of 401 and IRA accounts to exceed 15% - 20%. If I choose to retire in five years, I should be able to convert my 401 into an IRA, and invest the money as I see fit. This is not an ideal situation, but any money I put into a 401 would translate into immediate returns of over 1/3 the invested amount, because of tax savings. To me, investing in index funds and not in individual dividend stocks is worth generating a 33% return through the instant tax savings. Most of my current 401 money is in an old 401 from my last employer that I left in the prior year. I plan to roll this into an IRA, which would allow me better flexibility with my investments.
The second issue is that funds in tax-deferred accounts such as 401 and IRA cannot be easily accessed at a whim. There is a 10% early withdrawal penalty on money that is withdrawn prior to ages 55 for 401 and 59 ½ for IRAs. In addition to that, investors need to pay ordinary tax rates on money that is distributed. Investors in Roth IRAs can withdraw contributions without any penalties, but they do not get a tax break for contributing today.
So to summarize, I am better off getting tax deduction today that allows me to save an amount each year, which is lost for me when paying taxes. I am much better off to have some claims to money in the future even if accessing it is more difficult, than to simply throw it away (by giving it to the federal and state and local governments). The rate at which I will accumulate individual dividend stocks in taxable brokerage accounts would decline from 3 new purchases a month to 2 purchases every month. An interesting fact is that when I increased my 401 contribution from 6% to 10%, my paycheck decreased by a minimal amount.
Throughout my early retirement, I expect that the majority of income will come in the form of dividends, distributions and some 1099 business income. This would put me in a lower tax bracket, which is why distributions from an IRA in early retirement would still be a cheap way to withdraw money if I had to, even with the 10% penalty on distributions. However, if I choose to go to Substantially Equal Periodic Payment arrangement, I might end up withdrawing dividends from that IRA, without having to pay the 10% penalty. I found two calculators behind SEPP here and here. Depending on your age at retirement, the distribution you can take without paying the 10% penalty could cover 50% - 75% of your annual dividend income earned from that particular portfolio, assuming a current yield around 3.50% - 4%.