In Part 1 of this series, I wanted to use the actual tax code to see for myself if having tax-deferred accounts for dividend growth stocks is really a good idea. I am all for 'Roths', be it an IRA or a 401(k) - pay the tax now and know it is tax free when you want it. But does the idea of deferring the tax sound better than it really is?
We used our theoretical male who inherited $20,000 in 1981 and invested it all in Coca-Cola (NYSE:KO). Over the last 25 years, the asset is now worth $1.14 million dollars and has given us a dividend income stream of $28,500 in 2006. Over the last 25 years, he has paid nearly $52,000 in additional taxes because KO pays a dividend.
At the start of 2007, our gentleman has retired at the age of 65. In our alternative universe comparison, he only has two sources of income: Social Security and his KO stock. Because the taxable KO has been a "closed account," the taxes were paid from his working salary, we can now decide which way would have been better: Having the KO shares sheltered in an IRA all these years or paying the taxes on the dividends along the way?
I want to note two things before comparing the numbers. I am not a Social Security expert and there is no historical calculator to see what your benefits were for the years 2007-2012, so I looked at the historical tables and used that as being accurate to what our gentleman would have received from the government. Second, to simplify the tax code, the entire distribution was taxed at 25%. I know that it is a tiered system and only the next dollar in the 25% bracket gets taxed at 25%, but I am doing this to simplify things slightly.
The first table shows KO in a taxable account. The numbers are as follows:
|Year||Annual Dividends||Cost Basis||Stock Price 48.25||Value of stock||"100% Salary"= Distribution||Social Security||Dividends||Income Gap via Salary||Starting shares||Shares Sold||Shares Left||Tax Rate||Taxes Paid||Net Proceeds||Cumulative Taxes Paid|
I calculated that all 23,000+ shares had an average cost basis of $11.00 per share. The value of the stock was determined by the last trading day of the prior year (the stock value for 2007 uses the December 30, 2006 price). The "100% salary= Distribution column" is my way of saying the gentleman wants to replace 100% of his current salary with a continued 3.5% raise for inflation. This is the dollar amount we are trying to replicate with Social Security + Dividends + Any shares we may need to sell before taxes. The Income Gap column is the dollar amount we are short and is needed to calculate how many shares we will need to sell to keep our current standard of living. The final two columns are the crux of the article (and the discussion): How much money do we have to play with for the year? And how much in taxes have we paid over time?
Because we are not taxed on Social Security and the selling of shares due to long term capital gains and the dividends are only taxed at 15%, we have an effective rate of 12-13.5% and are only paying $7,000- $8,500 each year for the next 5 years. Our cumulative taxes paid up to 2011 is just under $90,000 over the last 30 years.
What about if this KO stock was in an IRA instead? All the values are equivalent except for the last 4 columns: Tax Rate, Taxes Paid, Net Proceeds, and Cumulative Taxes Paid. Below is the side-by-side comparison:
|Tax Rate||Dividend Taxes Paid||Net Proceeds||Cumulative Taxes Paid||(Age) Year||"100% Salary"= Distribution||Tax Rate||IRA Disbursal Taxes Paid||Net Proceeds||Cumulative Taxes Paid|
|15.00%||$ 7,009.45||$54,139.51||$58,750.38||(65) 2007||$61,148.96||25.0%||$12,485.24||$48,663.72||$12,485.24|
|15.00%||$ 7,172.34||$56,116.84||$65,922.71||(66) 2008||$63,289.18||25.0%||$12,954.30||$50,334.89||$25,439.54|
|15.00%||$ 7,547.62||$57,956.68||$73,470.34||(67) 2009||$65,504.30||25.0%||$13,343.08||$52,161.23||$38,782.61|
|15.00%||$ 7,951.76||$59,845.19||$81,422.10||(68) 2010||$67,796.95||25.0%||$13,916.24||$53,880.71||$52,698.85|
|15.00%||$ 8,328.93||$61,840.91||$89,751.02||(69) 2011||$70,169.84||25.0%||$14,509.46||$55,660.38||$67,208.31|
|15.00%||$ 8,681.10||$63,944.69||$98,432.12||(70) 2012||$72,625.79||25.0%||$15,012.45||$57,613.34||$82,220.76|
We can see that the piper is now being paid to the tune of 70% more in taxes each year by having our money in the IRA. He also has 10% less disposable income every year taking distributions from his IRA versus paying the capital gains and the dividend tax. If we continue to extrapolate our findings, I find the crossover point to be around the 2016-2017 timeframe where paying the dividends and selling shares from a taxable account would have been more advantageous provided our gentleman reaches 75 years old.
There are 2 points we need to consider and no one has an idea about the first. What will the tax rates be moving forward? This obviously changes the extrapolation since this was using recent, accurate history. I can't project what will happen but my assumption will be that taxes will rise. Will it only be for capital gains? Dividends? Income levels? All of the above?
The second point is the Distribution column. I assumed our gentleman wanted the same standard of living during the years of 2007-2011 as he did when he retired in 2006. In 2012, he had to take out an RMD equivalent to 3.77% of $1.55 million dollars. The RMD equals $58,470. The distribution of $72,625 was 4.69% of the IRA account value for 2012. After 5 years, he should have a confident idea of what his expenses are and the quality of life he wishes to pursue, but just as we like to see our dividends compounding over time, inflation begins to compound against us as well.
I know our example cannot take into account every real world variable, but I think people may want to reconsider stuffing everything into a tax-deferred account. With the tax code alkready mandating a rise from 15% to 18.6% on dividends and being up in the air along with the looming deficits from the local to the federal levels, we investors may be in for a rude awakening when it's time to withdraw funds from our tax-deferred accounts on how much after-tax money we will have to enjoy our daily lives. Sometimes the known is better than the unknown and I think this may be one example where we are better off paying taxes on our seeds each year versus being taxed on our plentiful harvest.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.