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Aim For The Sweet Spot

Investopedia describes the "Sweet Spot" as "The point at which an indicator or policy provides the optimal balance of costs and benefits... often used to refer to situations where economic data... are... expected to lead to the best overall economic situation."

When sitting down and figuring out your retirement philosophy and goals, this should always be on your mind. The essence of this overall idea can be boiled down to one word: Efficiency. In fact, every day you live your life, efficiency should be a key factor in the decisions you are making. You should always be trying to get the most benefit from the least amount of investment. By using the word "investment," I don't necessarily mean a monetary investment, such as a stock or bond. It could mean an investment of your time, your ideas, a temporary loan of some resources or product(s) you own, etc.

Taking a cue from Mr. Money Mustache, last year I bought a bicycle. I've used it to ride to work over the last year (a roughly 3 mile ride each way.) My car gets about 20 miles to the gallon. I ride to work roughly 200 days a year. I actually work about 250 days a year, but I've tried riding in snow and ice, and after falling a few times, I decided I'm just not that hardcore. So lets just use 200 days instead. That's 6 miles roundtrip times 200 days equals 1200 miles per year. To drive that 1200 miles instead, my car would take 60 gallons of gas, since it gets 20 miles to the gallon. (60 x 20=1200). Gas costs roughly 3.40/gallon, (60 gallons times $3.40 would cost $204), so my bike is saving me about $200/year. Not going to get rich off of it, but hey, I'll take the $200 over nothing.

Actually, the health benefits of the daily workout I get by riding far outweigh the monetary benefits, plus I have no need to join a gym anymore. So technically you could take what I would have paid towards the annual cost of a gym membership (lets say $30/month x 12 = $360/year,) add it to the yearly savings of $204, and the amount would almost triple to $564. Of course you have to deduct the cost of the bike itself (I bought mine new for $400 which was not the best choice, better to pickup a barely used one on craigslist for a third of that) and you have to factor in maintenance, etc, but overall it makes sense to do. This is just one example of how you should be thinking of efficiency in every area of your life.

In terms of your investments it goes without saying that you should put a lot of thought and research into what type of investing you want to do (index investing, vs. Dividend Growth Investing vs. many other options out there.) Even if you choose index investing, which is generally considered the easy "hands off" choice, you still have to determine your asset allocation. Yes, it is true you are buying index funds, so you don't have to worry about specific companies, but you still have to determine how much you want in stock funds vs. bond funds vs. real estate (REIT) funds. And then in stock funds, you have small cap stocks vs. mid cap vs. large cap, and you've got European stock funds vs. pacific stock funds vs. emerging markets stock funds. Like anything else, the more you start learning, the less you realize you know and it gets more and more complicated as you dig deeper and discover more "gurus" and "experts," all with their own theories, books, blogs and formulas. Some people just try to keep their percentages close to what the overall market percentages are, which is one (not bad) way to approach it. Other people just hand their money over to a financial adviser they trust and pay the associated fees. I personally like to get involved and learn about everything I do, so the adviser option would not work for me.

If you decide on Dividend Growth Investing, which I assume you have, or at least you have some interest in it since you are here reading this blog, then there are two major factors that you should figure out when you are getting started. The first is which companies to invest in. This is not the point of this post, so we'll leave that criteria for another time.

The second is "how much" you are going to build up in your nest egg before you choose to retire and start living off the dividends. This is also known as "pick your number." You have to be careful doing this, because our natural inclination as human beings is to always want more. Many many people make millions or even billions and it is never enough. They are never satisfied. Don't be stuck on a treadmill where the goal is always just "another." Another 10 grand, another 100 grand, another million. Think about it and pick your number.

In picking my number, I tried to pick the most efficient number possible, also known as the "Sweet Spot." Remember, this is what gives you the most benefit with the least cost.

To understand this, we need to talk taxes. Taxes definitely qualify as a cost. For most people, they are single biggest cost they pay, especially if you are in the higher income brackets. Most corporations pay dividends which are considered "qualified." This means they qualify for a reduced or eliminated tax rate. There is some fine print regarding qualified dividends, such as you have to hold the stock for a certain amount of time, etc, etc, so make sure you do your research first. Here is a link to a Wells Fargo page which covers it in a bit more detail. If you are in the bottom (10%) or second from the bottom (15%) tax bracket, you will pay no tax at all on qualified dividend income. So, the sweet spot here is for your qualified dividend income to be at the very top of the 15% tax bracket, in which case you will pay exactly zero in taxes. In 2014, for a married couple filing jointly, that number is $73,800, a very livable wage, especially if you've managed to pay off your mortgage and have no other debt once you retire. And keep in mind that you aren't paying social security, Medicare, unemployment or any other payroll taxes that the poor schlums receiving regular earned wages have to pay. So realistically, that $73,800, all of which goes into your pocket, is basically equivalent to earning six figures at a regular job.

Using our universal reasonable payout percentage of 4%, you'd need $1,845,000 investing in companies which pay qualified dividends to meet this goal. Also, don't forget that that number is (usually) raised every year to account for inflation. This is great since most of the companies you are investing in should be raising their dividends as well, (after all, why do you think they call it Dividend GROWTH Investing...) So every year, the amount you are allowed to make without paying any taxes will go up, and the amount your companies pay you will go up. Sounds like a pretty good life to me.

Yes, it is possible that they could change the tax code sometime in the future and qualified dividends could lose their special status and be taxed as regular income. It's also possible an atomic briefcase bomb could be snuck into the country by terrorists and your city could become a desert of black glass in a few seconds. We can only deal with what is the current situation (as long as it is reasonably likely to continue) we cannot make prudent decisions based on what may or may not happen sometime long into the future.

But wait, there's more! I sound like one of those late night TV salespeople. When you do your taxes, you also get to apply a standard deduction amount AND a personal exemption amount which can offset any non-qualified income. For a married couple for 2014 the standard deduction amount is $12,400 and the personal exemption is $3950 per person, including children. In my case, we happen to have two kids, so we would add the $12,400 standard deduction to the $15,800 personal exemption amount ($3950 x4) and that would come to an additional $28,200 ON TOP of our $73,800 qualified income.

I can hear what you are thinking: "Wow, that's over ONE HUNDRED GRAND ($102,000 to be exact) and the government doesn't get a single penny!" Actually that may or may not be true. There's something called the AMT, or the minimum alternative tax. This kicks in at $82,100 for 2014. That means if you make more than that, you may be subject to the AMT and you might have to pay tax. You might also live in a state which has state income tax, in which case you might still have to pay state taxes on your entire income. I live in a state with no state income tax, so I don't have to worry about that. You should think about moving if you do. The tax code is something like 80,000 pages, and I am not a CPA, so there is way more involved in it than I can cover on this blog. And you should definitely see an expert about your situation. But if this post has got you thinking and wanting to learn more about it, then you're already headed in the right direction.

*For those of you who feel this is morally wrong in some way, I should remind you that by the time my journey is over, I will have paid several million dollars in taxes over my working years, which I consider far, far more than my fair share. I have no problem obeying the tax laws in such a manner that will allow me to legally keep my money.

Some investments such as REIT's (real estate companies), MLP's (Master Limited Partnerships) and some other types of companies pay dividends which are not considered "qualified." Personally, for simplicity's sake I don't mess with MLP's, or BDC's. I do, however think real estate companies (REIT's) can be good investments and a nice aspect (but small percentage overall) of your portfolio. They tend to have a bit higher yield which boosts your overall portfolio yield, and they can also help to lower the volatility of your portfolio since they often move in the opposite direction of the overall market. Fortunately, the standard deduction and/or personal exemption amount can be used to offset your REIT income. Assuming REITs pay a slightly higher percentage overall than 4% (let's say 5%, although often it can be even higher than this,) you would need $248,000 in REIT investments to provide you with $12,400 of yearly income at 5%, which could then be offset with your standard deduction.

As a side note, some people might want to use their standard deduction to offset their REIT income, and then use the personal exemption to offset any small side jobs they've taken during the year, or some other rental income they might have, etc. It's all up to you. My "number" is to have the maximum in both ($1,845,000 in qualified dividend stocks and $248,000 in REITs, plus use the personal exemption to offset income from a commercial property I own, making my overall nest egg goal just under 2.1 million, not counting the value of the commercial property) but of course your plan might be considerably different. If you are single, you can pretty much cut all the numbers in this article in half. But you also have half the people to support off the income. It's not hard, get on Google and start looking up tax brackets, etc. Learn all the facts so you can develop your own unique plan which matches your lifestyle and goals so that you can hit your own sweet spot. Happy saving and investing!

For further reading, check out gocurrycracker's great post on the subject: http://www.gocurrycracker.com/never-pay-taxes-again/

And, a very useful tool is the TurboTax Taxcaster, which you can plug in your specific info and see what your taxes would be: https://turbotax.intuit.com/tax-tools/calculators/taxcaster/ They generally update it every year. It also exists as an app you can install.

Just out of curiosity, I plugged in $72,500 (the top of the 15% tax bracket for 2013) in qualified dividends, and $27,800 in "misc income" (the area for non qualified dividends), for a total income of $100,300, and entered my info as a married couple filing jointly with two children (with no other specifics) and it said I would owe exactly ZERO in taxes.