You may not think about it, but taxes eat away at your investment returns. Most people tend to focus on their rate of return without realizing that legally avoiding taxes through a tax-advantaged retirement vehicle can easily contribute to a 25%+ return depending on their tax bracket. If you have a large dividend portfolio, your dividend income would get taxed every year. Although your qualified dividends will get taxed at a lower rate, those taxes still add up over time. Thankfully, you can use a Roth IRA to avoid taxes on your investment earnings.
What is a Roth IRA?
Previously, I had written about IRAs here. An IRA is just a retirement vehicle that allows you to contribute money towards retirement. For a Roth IRA, you can contribute up to $5,500 for 2016 (contribution limits are phased out after a certain income level) of your post-tax income annually as of today. Inside the vehicle, you can use that money to invest in a variety of stocks and funds. When you hit 59.5, you can withdraw your contribution and earnings tax free, assuming your money has been in the account for 5+ years.
What is the Strategy?
I had previously written about retiring with dividend stocks. If you wish to pursue a retirement strategy consisting primarily of dividend stocks, you can max out your Roth IRA contributions and use those contributions to invest in high-quality dividend stocks and funds. You would then reinvest all the dividends that are earned back into more stocks.
By utilizing a Roth IRA, you will avoid taxes on all your dividends. You can take those dividends and reinvest them back into your stocks without paying any taxes. Normally, you would have to pay taxes on your dividends which would eat into your returns. Depending on your tax bracket, you could save more than 15% by avoiding taxes on your dividends (which in a way is a 15% return).
You also avoid paying taxes on capital gains, which may save you at least another 15% depending on how long you held the stock and what income bracket you’re in. A capital gain is the gain in stock value from selling a stock driven by price appreciation; it is the opposite of a capital loss. If you notice that a certain stock has appreciated significantly and you feel it is overvalued, you can sell it without having to worry about the tax implications.
Although you’re not supposed to take withdrawals from your Roth IRA until you are 59.5, you can still do it if you want to retire early. You won’t get taxed if you withdraw your contributions since you’ve already paid taxes on them. If you take out your earnings, you may get penalized at 10% on top of the ordinary tax rate you’ll pay depending on the circumstances. That might seem bad, but keep in mind, you’ve avoided taxes on your IRA earnings at potentially 15%+ rate for years. With that in mind, paying a 10% penalty doesn’t sound all that bad, especially if your overall income is low during early retirement since you’ll be in a lower tax bracket.
Suppose you started investing in your Roth IRA at 22 by maxing out your contributions ($5,500 annually) from age 22 to 59.5. I’ve charted out the scenario below. You’ll have over $1.1M that you can withdraw tax free. If you follow the 4% rule of withdrawal, you can withdraw over $40K per year tax free. If your portfolio is full of dividend stocks that you’ve accumulated over the years, you could be collecting well over a 4% return from dividends alone. If you want to retire early, you can start withdrawing your contributions.
The biggest limiting factor to consider is that a Roth IRA limits your contribution to only $5,500 (as of 2016) per year as a single person. The government needs to make its money somehow! As a result, you’re prevented from quickly accumulating substantial sums of tax-free investment earnings in your Roth IRA.
Another limiting factor is the age of withdrawal. If you withdraw your earnings before age 59.5 or before your earnings have sat in the account for 5 years, you have to pay taxes and a 10% penalty. Please see this website for more detailed rules regarding Roth IRA withdrawals.
By accumulating significant assets within a Roth IRA, you give yourself options for retirement. You can retire early and start off by withdrawing your contributions. If you run out of contributions, you can take a 10% hit on top of your ordinary income tax rate which really isn’t that bad considering all the benefits you’ve already reaped. Furthermore, if your income in retirement is low, your tax rate will be low anyway. Once you hit age 59.5, you can withdraw money without having to pay any penalties. If your earnings have been in the account for 5 years or more, you'll even avoid taxes. Therefore, I highly recommend that you consider this dividend retirement strategy.
I am not a tax or investment professional. Please consult with your accountant or financial planner before making any investment decisions.
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