Strategy Adjustment – Taxes… (Series, Part 1)

Very strange article title, isn’t it?  To begin, I love dividend stocks to invest in.  I love the pursuit to financial freedom and to be completely independent in the decision of what to do with my time.  As with that time – happiness is what truly matters, and making a difference in others lives.  I want to do that, NOW, Tomorrow, the next day and so on.  I want to be able to spend as much time with friends and family as I see fit in my life and to help others that are in need.  In doing some “deep-thinking” on how to further expedite this, maximize my money, which buys time, I have changed a strategy of mine.  The target?  Taxes.

Capture

The Strategy

When thinking about everything, it lead to some immense thoughts and analyses.   Bert can tell you the countless calls and my girlfriend may be sick of me by now with the debates and questions.  There really are multiple approaches and items within this strategy, we can call it a 3-way or a 3-part strategy, with the focal point on taxes.  Not just saving on taxes, but taxes with secret “back doors”, to make this more exciting.  I mean, come on – who doesn’t want to reduce their tax burden while protecting assets?  And who wouldn’t want to walk through “secret” or “back” doors.  To begin, I already save approximately, at a minimum, over 60% of my income each and every month.  Therefore, investing capital, luckily for me, has never been a huge problem.  If we include dividends in 2015, I had over $37,000 invested with my two hands into the market.  Even when excluding those dividends – still eclipsed almost $32,000 – to me, that’s a fricken ton of money!  Now what if, WHAT IF, I could have more funds at my disposal without negotiating my salary or shaving any further of my living expenses?  We all know that I believe, wholeheartedly, in the concept of every dollar counts, and this is no different.  Taxes.  The biggest expense I have, Uncle Sam’s taxes.   We all know about my struggles during the first 4 months this year, having some big tax payments in April to make (let’s say over $2K I owed).  I looked back at 2015, and I paid a whopping $19,046 in state/local/federal  taxes!  This doesn’t even include FICA, Property or other form of taxation throughout the year.  How amazing is that?  Well, I guess not too amazing, since that’s almost $2K per month gone, out the window.  Now what could I do to reduce that, without reducing the money coming into the pocket?  Insert – Strategy 1.

Strategy 1 – change to and maximize traditional 401k

Up through my first employer-pay of June 2016, I was invested into a Roth 401K at only 5% per pay, as my employer only matches a maximum of 50% of our first 5%.  When I was growing up, in my college courses and any other “general” personal finance  book or article talked about why we should all invest into any form of Roth if we can.  I drank that koolaid for some time now, and don’t get me wrong – it is a GREAT vehicle and a great account to protect after tax-dollars, hands down.  So of course, in my situation, with my “little” 5% contribution, I was paying with post-tax dollars, all because I used to think Roth was the sheer one and only true way to go, that if you did the traditional pre-tax 401k route, that you were out of your mind!  Well, I no longer think that, at all.  This is especially after reading about different conversions you can do, ladder step-ins with the traditional to a Roth, i.e. the backdoors.   The reality clubbed me smack in the face with how much you can save – with heavy thanks to Madfientist articles (whom I HIGHLY recommend if you want to get down to pure numbers and strategies).  It is amazing to find out that there are backdoor strategies to legally convert Traditional 401k funds to a traditional IRA and then from there to a Roth IRA, it takes dedication and time to perform this strategy but I highly recommend readying THIS ARTICLE to help build the case.

To lay retirement facts – for 2016 the maximum you can contribute to a 401k with an employer sponsored plan is $18,000.  Now, since I have contributed through 5.5 months worth of a Roth 401k, I won’t be able to do a full traditional-401k at $18,000; but somewhere in the mid $16K range.

I have decided to switch and have had my last pay in June and first pay in July already as Traditional 401K contributions (pre-tax).  By adding $16,500 (for easy math), this will save at my 25% federal bracken, 3.5% local tax and approximately 2.5% state tax a total of $5,032.50 in taxes (below).  Most may use this money to fund a new car, home theater, swimming pool, or pay down other things.  I am going to INVEST this.  Why?  Because EVERY DOLLAR MATTERS!
401k and tax savings

So what just happened?  I invested, what I normally do regardless, into a pre-tax 401K and it gave me an extra $419 per month to invest in.  I normally would have only contributed a minimal ~$3.75k into an IRA and I just sprung to $18K, pretty intense.  How’s that?  Think that’s pretty cool?  I know, I know – the comments of:

“But.. you can’t touch that before 59.5 or you’d face penalties beforehand, and you have to pay taxes on all gains and growth” – there are ways to suppress any damage if you need to access this early, which MadFIentist kindly explains.  Reference his article above.  We can all convert because we are all going for financial freedom.  Our taxable income is going to be so low, that you can transfer/convert, slowly, funds from one account to another, with little-to-no taxation or penalties.  But it takes HARD planning to do this.

“But you are limited only to investments that your employer offers in your plan.” – This is VERY true.  I love dividend stock investing.  Guess what?  I’m not stopping, and based on last year – I can more than likely still do $14K on top of $18K oh and let’s throw in another $5K in tax savings, so do not expect to have an immense slowdown, at all, into my dividend investing endeavors!  In fact, this improves the overall investment.

“But still, you have more funds going into a mutual fund” – my investment is Vanguard Institutional Index (VINIX) – a low as heck expense ratio.  Newsflash investors – It is very, VERY difficult to beat the market consistently for a long period of time.  I’m not saying I can’t (Cocky, I know), but the VINIX investment is not a BAD option – the growth rate is great, yield is at or above the S&P and they pay quarterly, I’m “Cool” with that.

“What about the yield?  It is roughly between 2.25-2.50% on the fund, where you can invest and receive 3.5-5% on stocks” – This is true.  However, I am capturing the entire market and the growth rate of the dividend on this is right where you want it to be 7%+ for a very, very long time.  I expect this to continue, therefore, in time it comes out “just right” with a growth rate over my entire portfolio and combination dividend impact of close to 10%+  I think I can say again, I’m “Cool” with that.

It doesn’t stop there…  there is another strategy and impact from this first one and that is…. —> (To Be Continued… See Part 2 here)

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30 thoughts on “Strategy Adjustment – Taxes… (Series, Part 1)

  1. I am glad you are maxing out your 401K plan. I have been talking about tax deferred accounts since 2013, but few dividend investors listened. By maxing out tax deferred accounts, I will be able to become financially independence much earlier. You should invest the tax savings through a Roth IRA. If you can, you can also do a regular IRA and save even more on taxes.

  2. I just read his article and wow the numbers were insane. I was taught to use a ROTH in my personal finance class so the numbers really drove it home for me that I have been lied to! Sadly as an international student I need to wait a year to see if I get a work visa otherwise I have to peace out so I will need to delay any contributions for a year as I am not sure how to withdraw from a traditional without penalty.

    • Stefan,

      Thank you for the comment, I really appreciate it. The numbers drive my mind up the wall, so far up the wall! I do wish I employed this strategy far earlier in my career, as you said it – I was beaten down with Roth IRA and was stubborn to say – I only wanted to do up to the match amount, but wow, I completely turned the other direction on this. Just so incredible. Speechless still sometimes. Get that work visa and let’s get it in movement!

      -Lanny

  3. Taxes and death are certainties in life. Whatever you can they improve the tax situation will help. I’ve deferred my investments for 20 years in my 401k. It’s even better due to employers contribution. It’s a balance though – if you need the money earlier, then you need to plan ahead. So different people will have different strategies.
    D4s

    • D4S,

      Couldn’t agree more – different people will have different strategies, as different mindsets will come with those individuals. With retiring early – you can potentially have a very low amount of actual taxable income, thus employing some of the conversion strategies at a lower-tax/to no tax, than being taxed now. It’s VERY very interesting and I think I can see myself employing this strategy well. Looking forward to the finish of this year to see how I can do. It’s a journey and this is a test.

      -Lanny

    • IH,

      Thank you and that’s awesome you’ve come across his articles and see the scene he is seeing. The first real test will be in 11 days and August will be the first FULL month of this. Eager to test this out.

      -Lanny

  4. Three rules I followed:
    1) Don’t leave any match on the table
    2) Protect the principle from taxation as much as possible
    3) Invest (after tax) as much of the remainder as possible.

    If needed there are exemptions for medical. Then there’s SEP. Plus rollovers. The real key is the match – it tends to minimize the ‘downside’.

    • Charlie,

      Thank you and I agree:

      1.) FOR SURE contribute to the match.
      2.) Hands down – be SMART. Plan. Strategize. Execute.
      3.) Invest, if you save money, invest more, if you save on taxes, invest more, repeat.

      MM hm. Keep it coming Charlie. LETS GO.

      -Lanny

  5. Have you ever considered investing in a dividend growth ETF or mutual fund? It seems like a lot of work to pick stocks individually and you also run the risk of stock risk. I like the idea of dividend investing but that is how I would prefer to do it.

  6. I jumped off the Roth 401k bandwagon last year. While I still have a Roth IRA for tax diversification reasons, I am on pace to max out my traditional 401k for the first time this year. It also makes sense for me to contribute into our 401k because we have multiple Vanguard funds and no extra fees on the fund because the company pays them instead of passing it on to the employees, which is great.

    Glad to hear you are making the switch over and concentrating on minimizing your taxes a bit more It feels a lot better doing this strategy after reading everything the Mad Finentist has written on the subject!

    • IPD,

      Nice, nice – interesting to see so many who used to be on the Roth train earlier on. Very sweet that you’re maxing out – how much are you estimated to save in taxes and then are you looking to invest that? Also – sweet work with the fees : )

      Mad Fientist really smacked me hard, which is funny, and I’m trying not to be upset by why I never did this in the past. Pumped to see this come to fruition.

      -Lanny

  7. It is great reading the articles from “young guns” like yourself and others about taxes. I have noticed that for a few bloggers in this community that are in their late 20’s that they are starting to look at taxes differently. It started off that we loved dividend stocks and put all into taxable account. Now we are switching over to maximizing 401k’s first.
    I’m assuming this has a lot to do on the fact that we are making more money, have a substantial cash/equity position that can be pulled out immediately if needed for a big purchase and the 401k to IRA ladder is becoming more common place.
    This past year, my wife and I hit the point where our portfolio can pay off our mortgage. It was really the turning point to maximizing out the 401K. Now, we can both lose our jobs and still have a roof over our head working a minimum wage job if needed.
    Now the inner battle between cash out and pay off the house, or let it ride…

    • ADD,

      Comment is awesome. Taxes are critical and deep thinking & strategy/having an open mind is key as well. I was the same way – all taxable, post the ROTH IRA account. Once work started – contributed to match for roth 401k. Now… Just completely changed, like that – maximizing that 401K, saving SO much money, lowering my income further, which… (stay tuned to next post!!!)….

      But bottomline – the ladder is now more common place and I cannot wait to use it. I’m in a similar boat – i can payoff the mortgage and car in no-time with my taxable account and shovel crap for a living. It’s all very interesting. Excited to see it all coming to action!!!

      -Lanny

  8. I started to try and optimize our tax situation too towards the end of 2015 and the first part of 2016, but it’ll be difficult to do too much with now since I’ll be a stay at home dad. Our total taxes paid were pretty ridiculous too which was the big reason that I wanted to try and optimize it. Even if the investments aren’t going into exactly what you’d like to invest in the added investment capital is more than enough to make up for it. And like you and Mad Fientist mentioned there’s plenty of ways to get at the money earlier than 59.5 and even end up paying no taxes on it depending on where your income falls when you go to convert.

    • JC,

      Nice – so you tried to optimize/maximize your dollars as well then, eh? This is the true-first year where I am focusing on taxes and taking down the beast. I typically have found out I do things in that manner – if something happened that I didn’t like – I go extreme to fix it i.e. when I owed more than I expected in tax dollars this year. I’m pumped to do it.

      Like you said – there are a plethora of ways to use/have access to the funds before the age, and I’m looking forward to figuring out the best way to do just that. Thanks for the support, I truly appreciate the comment, the stop by and everything JC!

      -Lanny

  9. I’ve been maxing or at least trying to max(I didn’t make enough early on) all my tax-advantaged space because the benefit of tax free growth when it comes to dividends and reallocating resources cannot be ignored.

    Dividends are great but they’re so much better when you get the to keep them all and reinvest them instead of paying 15% or more to the tax man. That 15% compounded across many years will be pretty huge in the long run. I also like how easy they make reallocating stocks/bonds if you happen to follow an asset allocation plan. There’s no need to fuss around with money in taxable accounts and paying taxes on any gains.

    Naturally, taxable accounts are still a must since you can only save so much in tax-advantaged accounts and for some people – they’re not an option due to their income or job situation but I think tax-advantaged account should be the first ones you try to max out for all the benefits they offer.

    The only drag is the inability to take out the money in early retirement without jumping through a bunch of hoops but the tax savings are totally worth it!

    • Time In the Market,

      Great post. And yep – I wish I could go back and truly maximize the 401k with my employer. Better late than never, right?

      Also – with the 15% tax hit on dividends – you’re right, as well. Obviously, this will continue to build, regardless; but this is post-tax advantaged investments.

      Further, there will be hoops – but to get to early retirement – we do enough hopping, so might as well jump through a few more things, eh?

      Excited to finish off the remaining parts to share them with the community. Looking forward to saving a crap ton of money from my taxes, that’s for sure.

      -Lanny

    • ZJ,

      Couldn’t agree more. It takes a HUGE chunk out of the money that comes in – my goal now is to reduce that and have the “OPPO” effect and use the tax savings to invest even more. Putting more safeblocks on the money we earn, is the goal!

      -Lanny

  10. I still struggle with this as the plan my company is in has no decent funds and they don’t match until you have been with them for a year. Maybe next year I will revisit it. But in the end we should all strive to keep as much of our money as possible. My city has that credit thing so I don’t pay it (although they are looking to change that). Sorry to hear your at 3.5%.
    Later,
    DFG

    • Mark,

      Thanks for the post. How long have you been there and which fund companies? And wow – no local taxation? Mine is brutal: My city is actually “2.5%” but only accepts 50% of the 2% that I pay to Cleveland. I.E. I pay 2% to Cleveland, my city I live in accepts 1% and then I pay an additional 1.5% afterwards = 2%+1.5% = 3.5% aka money KILLER!

      I would say – contribute and save on your state and fed tax, but that’s up to you my man! Keep me posted/write back if/when you can, thanks Mark.

      -Lanny

  11. I maybe missing something very fundamental here. But doesn’t maxing out your 401k contribution reduce your take home pay, which thereby reduces your ability to invest in dividend paying stocks?

    • RJ,

      Great comment. I invest quite a bit, regardless, and yes – it reduces overall picking individual stocks, but I’m still investing into an asset that has around a 2.25% yield with an above ~7.50% dividend growth over the last few years at a low average point. I do agree – though – it shrinks my ability to invest into divvy stocks BUT – I still will invest around $2K per month into individual stocks.. aka, still getting the bang in there.

      -Lanny

  12. Hey Lanny,
    This is a very thought-provoking article and I appreciate your writing it. DividendGrowthInvestor also wrote one similar sometime last year. I am not sure if anyone has mentioned this but depending on which brokerage your company uses to administer their 401k, you may be able to perform a one-per-calendar-year rollover. My company uses Fidelity as their 401k administrator. Maybe it is just our plan or maybe this is Fidelity-wide (other readers could comment on this), but Fidelity allows me to rollover my contributions to a Traditional/Roth IRA once per calendar year. This can be very advantageous because it allows you to contribute up to $18,000 per year to either a Traditional or Roth IRA and then once per year you can roll this over and invest it in dividend growth stocks of your choosing rather than the limited fund selection provided by your employer. For those who max out their Roth each year, this strategy is an amazing way to by-pass the $5,500 per year limit and contribute upwards of $18,000 per year to a Roth.
    I thought I would share. I am not sure how many 401k providers offer this. Maybe I am just lucky 😉
    Kyle

    • CORRECTION: If you are capable of a high-enough savings rate, you can contribute $18,000 to an employer-sponsored Roth 401k, roll this over to a Roth IRA once per year and still contribute the annual $5,500 to that Roth. This brings the total possible annual Roth contributions to $23,500. That’s not a bad plan 🙂

    • Also (apologies for the multiple posts; thoughts keep coming to mind), correct me if I am wrong but the strategy you mention in this article is great IF you have no other forms of ordinary income coming in, correct? The situation my wife and I will be in when we are around our 40s and 50s is we will have income from a personal business as well as income from a business we will inherit (hopefully that will be when we are in our 60s) from my parents. I don’t think we would be able to use a ladder approach (Traditional 401k -> Traditional IRA -> Roth IRA) because we would have ordinary income from both a personal business and later on a business that we will inherit. Our best bet is to max out our Roth 401k, roll over the contributions to a Roth IRA annually, invest in dividend growth stocks, and then start a contribution withdrawal schedule that coincides with age 59.5. Thoughts?

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