Taxes And Dividends: The Yin And Yang Of Investing

May 18, 2012 12:30 PM ETABT, DOV, JNJ, TGT, XOM5 Comments
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Pey Shadzi's Blog
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Deep Value, Growth, Momentum

Contributor Since 2011

I'm an investor in his late thirties who knows how to have a good time and not live life too seriously. I'm an avid value investor, along with dollar cost averaging my retirement, though I occasionally jump off the beaten path and "gamble" on less certain assets.

A couple days ago I sat down with a hot cup of black coffee and my MacBook to update my dividend-receivables spreadsheet for 2012. As I scrolled through my Excel spreadsheet, tallying up all the dividends I've received this year, figuring out my grand total a wide smile came across my face. Four hundred eighty three dollars and forty nine cents of distributions for the year. As I confidently saved my file to the desktop and poured a second cup of coffee, I was feeling pretty good about my ability to diligently save and increase my count of high quality dividend-paying stocks in my taxable account.

But wait a second -- I faintly remember having to pay some taxes on my dividends last year, didn't I? Yes, that's right, I received $1,337 of dividends and was required to pay Uncle Sam 15% of distributions, or $200.55 in 2011. As I sat down to review the numbers again, my feelings of excitement slowly turned to feelings of indifference as I realized how much tax I'll likely have to pay over the course of my dividend-reinvesting lifetime. Not to mention this scenario would look a lot worse should our leaders in charge decide to effectively hike up the required taxes on dividends in the future. Man, when you think about it, a guy just can't win in this game.

Over the past four months, I've written quite a few articles here on Seeking Alpha touting the benefits of investing in dividend-paying stocks like Johnson & Johnson (JNJ), Abbott Laboratories (ABT), Dover Corporation (DOV), Exxon Mobil (XOM) and Target Corporation (TGT). My overall thesis generally states that if you're able to continue adding to your account balances while reinvesting your dividends, you're likely to turn out one wealthy individual in the end should you begin investing relatively early on in life. One topic I realize I've failed to explore, however, is what type of account is best for holding these stocks. Perhaps another topic I've skimmed over is the relatively high amount of taxes that will need to be paid on an ongoing basis over the years in order to reinvest in our future. Both of these topics should certainly be explored in more detail as they have the potential to "make or break" your long term situation.

First of all, I think it's safe to say that if you're qualified to contribute to a Roth IRA, you should certainly take advantage of this investment vehicle prior to placing your money in a taxable account. Since I began investing, I've faithfully funded my Roth IRA to the maximum -- alongside receiving a 100% 401(k) match at my place of employment -- prior to moving any money into my taxable accounts. This point is paramount if your long term goals are to build the maximum amount of net worth.

Secondly -- and this point goes along with the previous one -- it's very important to consider taxes in the overall scheme of things. It may feel exciting and exhilarating to check our dividend disbursements for the year and feel as if these dividends were somewhat akin to "having a second job," being the payments feel somewhat like "free money;" however, dividends aren't free and that second job still increases your taxable income considerably in the grand scheme of things. Just like the late rap star, The Notorious B.I.G., famously stated: "Mo money, mo problems." When you look at the implications of taxes on a taxable dividend portfolio, you realize how right he really was. Taxes eat up a considerable amount of value over time and, similar to the idea that dividends compound over time to build wealth, taxes also compound similarly to "eat up" our returns over time as well. It's certainly a point to keep in mind.

With that said, anyone who is capable of funding their 401(k) up to the match, fully funding a Roth IRA and has money left over after expenses to add this capital to a taxable investment account is likely doing fairly well with their quest to become independently wealthy. However watching your taxable investments and doing your best to keep as your tax liabilities low -- especially for us young guys -- will certainly help amount a considerably higher amount of wealth later on in life.

Continue to press onward with our wealth-building goals, my friends, but let's make sure we're utilizing our abilities and lowering our effective tax rates in order to ensure the most sizable amount of capital stays in our accounts. Best of luck out there!

Disclosure: I am long JNJ, ABT, DOV, XOM, TGT.

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