I am a do-it-yourself novice investor. I focus on dividend yield and dividend growth stocks. Over the last couple of years, I have realized that not all stocks are born equal. There are different tax implications of holding the same stock in different accounts. The aim of this article is to start a meaningful constructive discussion amongst fellow investors. I want to hear about your investment strategies - which stock do you hold in which account.
Allocating money to accounts
I wanted to grow our money tax-free or at least tax deferred. However, my wife and I are high-income earners (as per IRS) and we do not qualify for various income tax benefits. Last year, I realized that there is some hope for us. The IRS allows us to contribute $5000 to a Traditional IRA every year though we cannot claim any tax deduction since our joint income is more than $200K. So why does contributing to an IRA make it attractive? Because we can convert it to a Roth IRA immediately. Note that we could not contribute to a Roth IRA directly because of our joint annual income but this conversion provides us a backdoor entry into growing our money completely tax-free. We pay no taxes on the conversion amount since we contributed post-tax dollars to the Traditional IRA. Furthermore, the entire Roth IRA amount is tax-free because the initial contribution was post-tax. This lets us contribute $10,000 ($5K for each spouse) per year.
Matching stocks to accounts
We now have the following accounts
- Regular Brokerage
- Traditional IRA - but no funds to use since entire amount is converted to Roth
- Roth IRA
The following matrix gives my preferred mix-n-match option for a particular category of stock to a particular investment account. Most stocks can be held in any account with no catastrophe. This is really an attempt to optimize tax treatment to get a few extra points of return on investment.
(Click the chart to expand)
There are a couple of key differences between the two types of account. In a regular broker account, the dividends are taxed at a lower rate until the Bush-era tax cuts expire next year. Furthermore, capital losses/gains are taxed every year as per various IRS instructions applicable at the time of filing income tax returns. On the other hand, there is no annual tax returns filed for a Roth IRA account. For me, the entire Roth IRA withdrawals will be tax-free - initial capital as well as dividends and any capital gains.
I used to hold REITs and Preferred stock in my regular account until I did my first 1040 after buying them. I quickly realized that I was not getting the preferential tax rate of 15% for dividends. My effective yield had come down. Over the next year, I sold these stocks from my regular account and bought them at slightly lower prices using limit orders in my Roth IRA account.
A few months after I bought my first foreign dividend yield stock, I realized that there was a withholding tax on dividend paid to the country of origin. After the initial panic and dismay, I realized that all was not lost - I could claim a dollar for dollar tax credit for foreign taxes paid on dividends received at the time of filing 1040 using Form 1116. Slowly, I became a big believer of diversifying outside the U.S. and as I continued buying foreign stocks I realized that there are three categories:
- Foreign stocks that withhold taxes on dividends. These are best held in regular brokerage account since a credit may be claimed for the taxes paid when annual income tax returns are filed. Such foreign taxes would be lost if the stock were held in a tax advantaged account like Roth IRA as no annual returns are filed so no credit may be claimed
- Foreign stocks that withhold no taxes on dividends. There are a few countries that deduct no taxes on dividends. This is either because that country has no taxes on dividends whatsoever (even for their resident investors) or because they have a tax treaty with the U.S. These stocks can be bought in a Roth IRA account.
- Foreign stocks that withhold no taxes on tax-advantaged accounts but do so for regular accounts. There are a few countries who realize the issue with U.S. tax-advantaged accounts and give them a preferential treatment. The custodian is involved in the process but for the investor, there is no withholding tax if the shares are held in a tax-advantaged (deferred) account.
Finally, I learned another lesson on foreign stocks. A few companies are structured as dual-country listings. This gives rise to stock ticker symbols on the U.S. exchanges, one from each country of origin. The U.S. tax treaty could be different with the two country leading to different treatment of withholding taxes. For example, Unilever is an Anglo-Dutch company. The British companies ticker is UL and the Dutch ticker is UN. There are no taxes withheld on dividend from UL (converted from British pounds) but there are taxes withheld from UN (convereted from Euros). I obviously prefer UL though UN might work for others if they are bullish about Euro compared to Pound. Similar thing with BHP Billiton. BBL is British and no taxes while BHP is Australian and taxes are withheld.
I started out buying stocks hoping to get rich overnight. My slow transformation into a serious dividend yield and dividend growth investor continues. However, there will be occasions when I have the urge to trade. I guess the rush of shorting Netflix is just too exhilarating. Earlier, I did such trades in a regular broker account so that if I do incur trading losses then I can write them off against capital gains and/or income (limit of $3000 per year). Lately, I never had any losses but ended up having short-term capital gains so now I execute such trades in the Roth IRA account to avoid being taxed at regular income tax rate of 33%.
I do not have any money in the Traditional IRA account since I convert the funds to Roth IRA immediately. For a high income earner, I see no major benefits (if any at all) of investing via a Traditional IRA account.
I do not invest in Master Limited Partnerships but I believe they are best held in regular accounts and not in IRAs. I do not need current income via stocks and I find that there are enough other investment opportunities that I don't feel like monitoring another sector. I find it easier to understand manufacturing sector and technology stocks than partnership businesses.
Please note that I am describing my strategies. I am not a tax-expert and am not giving any tax advice whatsoever. Please do your own due diligence and please do comment on my strategy and share yours.