Is Dividend Mantra Wrong on Taxes?

This is the second article in my three-article series on deferring taxes in order to achieve early retirement. Please read my first article on the topic, as this one is a continuation of it.

The problem with my thesis is that $13,125 in a taxable account that yields 3% will generate $393.75 in annual dividend income that’s taxed at 15%. The net income is $334.69 if you collect the dividend income while you are working. If you do not have any taxable income, you would keep the whole $393.75 in dividend income, without paying any taxes. If the $17,500 that is invested in the 401 (k) will earn $525/year at 3%, that income will be tax deferred. However, if you wanted to access this amount before the age of 55 for 401 (k) and before the age of 59.5 if you converted to an IRA, you would pay a 10% early withdrawal penalty in addition to 25% if your taxable income is over $36,250. This translates into $354.37 in net dividend income if you paid taxes while you are working and you are younger than 55 years old. If you have zero taxable income however, you would only end up paying a 10% early withholding penalty, so would you end up with $472.50 in annual income to spend. As you can see, the savings add up really quickly in a tax deferred account. Those savings can result in higher distribution incomes for you to enjoy in your retirement.

Now, if at the time you retire you are over the age of 55 ( for 401K) or 59.5 (for IRA’s) or if you choose to do Substantially Equal Periodic Payments (Check Financial Samurai’s article on those), you can essentially avoid paying the 10% early withdrawal penalty. Therefore, for income under $10,000/year for singles, you would not owe any taxes whatsoever. If your taxable income is less than $36,250 for single individuals or under $72,500 for married individuals, you would pay 15% at current marginal tax rates. Therefore, if you are paying a 25% marginal tax rate today, and you expect to be earning less in your early retirement at say 10% or 15%, it makes perfect sense to use tax-deferred accounts to save. You would essentially be playing tax arbitrage, and be able to accumulate more investable assets to your name. More money on your name could potentially result in more income, when compared to a pure taxable investing only strategy with the same investments in focus.

The problem with my thesis is that 401 (k) plans are not available for all employees. In addition, 401 (k) plans are very restrictive about the types of investments you can make in them. In the case that 401 (k) plans are not available for you, you can put $5,500 in a tax- deductible IRA for singles or married taxpayers whose spouse is also not covered by a retirement plan at work. If you had managed to find a spouse who is covered by a retirement plan at work, you need to be making less than $178,000 in annual income. Otherwise, you cannot get a tax break by contributing in an IRA. With IRA’s you can put less than the amount of 401 (k) plans, but you have the option of investing in any security you want.

With 401 (k) plans, you might be stuck with high fee mutual funds, which could also be doing much worse than your plain vanilla index fund. Depending on the types of investments available in your 401 (k) plan, and the time you plan on holding on to that plan, it might not make sense to use this form of tax-advantaged savings. In most cases however, it might still make sense to do 401 (k) investing, even with a mutual fund where you pay 1% in annual management fees, mostly due to the steep tax savings you are making. It would especially make sense if you plan on rolling that 401 (k) money into an IRA within 5 years or so.

If your plan offers low cost index funds, it might be worth it to stick with them if you have only a few years prior to retirement. After you retire, you can convert this 401 (k) into an IRA, and buy the best dividend paying stocks.

Stay tuned for the third installment of this tax series tomorrow.

Full Disclosure: None

Relevant Articles:

- Why I Considered Tax-Advantaged Accounts for My Dividend Investments
- Roth IRA’s for Dividend Investors
- Six Dividend Paying Stocks I Purchased for my IRA
- Twenty Dividend Stocks I Recently Purchased for my 401 (k) Rollover
- Eleven Dividend Paying Stocks I Purchased Last Week