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Are You Costing Yourself 42%?

If you're a dividend investor, you're probably not too happy these days. Since the banking crisis started in September, dividend payments have been sliced and diced like veggies at a Japanese steakhouse.

The pain hasn't been limited by sector, either. In addition to cuts at major banks such as Bank of America (NYSE: BAC  ) , we've seen similar carnage at companies such as Dow Chemical (NYSE: DOW  ) , Toyota (NYSE: TM  ) , and General Electric (NYSE: GE  ) .

And with all of these cuts, one of the best arguments for dividend stocks -- that reinvested dividends buy more shares in down markets, thus softening your downside and positioning you better for the eventual rally -- has been shot to pieces.

But are you making things worse?

I was.
My own personal dividend sucker-punch came on April 15, when I got my tax bill. Because I keep most of my dividend stocks in a regular brokerage account, and because my dividend income didn't stop when the market hit the skids, I ended up in the ... umm ... annoying position of owing Uncle Sam about $500.

That's a tough pill for any investor to swallow, especially when portfolios are shrinking.

There are some easy ways to make sure you don't make the same mistake:

  • Double-check your tax forms to see that you're taking the right number of allowances. If you think you might be underpaying, you can elect to have extra cash withheld from your monthly paycheck to account for your dividends.
  • If you'd rather not touch your monthly income, make sure your brokerage firm is taxing your dividends as they occur. Doing so on the front end could protect you from an unwanted April surprise.

But there's another, bigger-picture solution. We here at the Motley Fool call it "asset location," not to be confused with its flashier, more popular cousin "asset allocation."

The basic idea is this: If you're saving for retirement, you should keep as many of your income-producing investments in tax-advantaged accounts (IRAs, 401(k)s, etc.) as possible. This may seem like a pretty simple concept, but its effect over the long term can be staggering.

For example ...
Let's imagine two investors who favor large-cap dividend stocks. Both start with $5,000 invested in dividend-paying stocks yielding at least 3%, and both reinvest every dividend they get. They invest for 35 years, and see the same yearly rise in stock prices (7%) and dividend payouts (5%).

Such companies are relatively easy to find, and often come with wide moats, great brand recognition, and dominant positions in their industries. Think companies like beverage behemoth PepsiCo (NYSE: PEP  ) and consumer-goods giants Procter & Gamble (NYSE: PG  ) and JM Smucker (NYSE: SJM  ) .

The only difference between our two investors is that Investor A's investments are in a Roth IRA, and Investor B's are in a regular brokerage account. As a result, Investor A only pays taxes on his money once -- when it gets taxed in his paycheck.

Investor B, on the other hand, gets taxed twice -- in his paycheck and on his dividend income. Over time, what looks like a small difference gets very big indeed.

Metric

Investor A

Investor B

Total Value After 35 Years Invested

$604,359

$425,350

Dividends Collected After Taxes

$382,286

$249,853

By investing over the long haul, Investor B turns his initial $5,000 into a pretty nice sum. $425,000 definitely won't be enough to retire on -- some estimates suggest you'll need $1 million in order to retire comfortably -- but it's a start.

Investor A, on the other hand, by holding his dividend-paying assets in a tax-advantaged account, gains an extra 42%!

But wait -- there's more!
Asset location is just one of the strategies Robert Brokamp writes about at Motley Fool Rule Your Retirement. Here's another tip about tax-advantaged savings: "The government spends more than it has, and it will get worse as retiring baby boomers strain entitlement programs," Brokamp writes. "Exactly how much taxes will increase is not known, but some experts believe taxes will be 30% to 50% higher. If you agree, then building up a stockpile of Roth assets is smart."

Brokamp has been helping Rule Your Retirement subscribers for more than five years now, and as part of this milestone, he's leading current members in a year of "Fiscal Fitness." Sound like something you might need? Take Rule Your Retirement for a spin with our no-risk 30-day free trial. Click here for more details.

Already subscribe to Rule Your Retirement? Log in at the top of this page.

Matt Trogdon owns shares of PepsiCo. Procter & Gamble and PepsiCo are Motley Fool Income Investor recommendations. J.M. Smucker is an Inside Value recommendation. The Motley Fool owns shares of Procter & Gamble and has a tax-advantaged disclosure policy.


Read/Post Comments (13) | Recommend This Article (93)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 22, 2009, at 3:58 PM, TimothyVR wrote:

    First you mention $5,000 as the initial investment.

    Then you refer to $10,000.

    Which is it?

    Or maybe I am raeding it incorrectly?

  • Report this Comment On July 22, 2009, at 4:43 PM, StartEarly wrote:

    This is great advice for dividend investors (typically either low-risk and/or close to retirement).

    However, for a young investor or those with high risk tolerance, you want to put your big-gainers into tax free accounts, and hold your dividend earners in taxable.

    You really don't want to preserve your 3% dividends and incur a tax penalty on your 50% capital gains!!

  • Report this Comment On July 22, 2009, at 4:59 PM, TMFTrog wrote:

    Thanks for reading, Timothy. It should be $10K both times. My apologies.

    Fool on!

    Matt

  • Report this Comment On July 22, 2009, at 9:30 PM, lebaresq wrote:

    Never participated in dividend reinvestment plans as I required dividends to supplement sole proprietor business income to make ends meet, avoided bother of parsing out capital gains & losses on reinvested portions if position cashed out. Program is best suited for compounding income & growth long-term within tax sheltered vehicle. If financial resources are of such magnitude to fund tax exempt investments generating income sufficient for one's life style, arranging high yield taxable and high capital gain eligible items solely in tax sheltered accounts is plausible, otherwise asset location is a balancing act.

  • Report this Comment On July 22, 2009, at 11:46 PM, robertf36009 wrote:

    Using a three pronged approach will help if your event horizon is fairly long. Invest in a Roth IRA manged fund with relatively low risk I use pioneer fidelity (PINDX) but any good one would do. The second leg is a Roth 401K hopefully your employer will have a matching contribution. The third leg is a brokerage account anchored in a tax exempt money market I use (USAA) but not everyone is eligible. However there are other comparable products available for anyone willing to do their due diligence.This approach lets you invest in as high of risk as you personally can tolerate by diversifying on your terms. While having tax sheltered managed accounts simultaneously with your own account with a tax sheltered base you win. You compound over time and retire profits into a sheltered account which you draw down tax free.

  • Report this Comment On July 23, 2009, at 1:27 AM, ThudThud1 wrote:

    Please check you calculations...They seem incorrect. Or at least share your assumptions so we can verify.

    When I ran some numbers and assumed dividends and growth compounded quarterly and a 15% tax rate, I got the following values:

    Investor A - $264,886 total dividends, $225,153 after taxes (you still will have to pay taxes when you withdraw from IRA)

    Investor B - $217,524 total dividends, $184,895 after taxes.

    This is only a difference of 40k

    Note, It might be more reasonable to assume yearly compounding in which case the differences is even less only 34k.

    Even if I jump the tax rate to 25%, the difference only increases to 47k.

    Your argument has its merits just not as much as you lead us to believe. And as StartEarly indicated if you are trading and realizing capital gains, things get even more complicated.

    Bill

  • Report this Comment On July 23, 2009, at 10:03 AM, romeczek wrote:

    Owing some money to the IRS in April is not the end of the world. Actually, it is preferable to a big refund.

    A tax refund is just the return of money you lent the government interest free.

    Just watch out that you do not owe too much to trigger estimated tax underpayment penalties.

  • Report this Comment On July 24, 2009, at 6:50 PM, Jacksschitt wrote:

    I retired in July of 06 from ATT. I have brokerage accounts and I have stand alone stock in ATT. I do not prticipate in dividend reinvestments since I take the accumulated assets to purchase more stock normally in a different sector. I am pretty even between the regular account and the IRA and the ROTH.

    When I start drawing down my IRA via the RMD's I will be taxed on that money at who knows what rate. With the morons that we elected its anyones guess.

    I use the income stream from my ATT dividends to pay for our Long Term Care insurance.

    We worked for what we have, we did not sue anybody. We did not take anything from someones pocket that they earned. I am still working part time so I can fund my ROTH IRA. Who knows how long I will have left so I figure the need is now. If Obama wants to reach into my grave to capture the last of my earnings and savings to redistribute the little bit of wealth that I have accumulatewd, thats the way it will be.

  • Report this Comment On July 25, 2009, at 3:16 PM, SbElectric wrote:

    I have DRIP accounts on a number of corporations where I put additional funds when I have spare cash. Can I place these accounts under IRA? The problem may come from investing additional funds.

  • Report this Comment On July 26, 2009, at 3:42 PM, wolfman225 wrote:

    I think some of the confusion is by people mixing up the Roth IRA with the traditional IRA/401K model. It's true that you will pay taxes on distributions/withdrawals from traditional IRA's and your 401K; but, since the Roth is funded with after-tax money, the withdrawals from that account (as well as the accumulated gains) are not taxed. At least that's my understanding of how the Roth works.

  • Report this Comment On July 26, 2009, at 3:47 PM, wolfman225 wrote:

    Just another thought. Given the assumption of greatly increased tax rates in the future, wouldn't it make sense to put the investments that you predict to be your biggest gainers into the Roth, as opposed to a regular IRA? I'd much rather pay the minimal rate I owe now on my income and avoid a bigger percentage bite out of a much larger pie later on.

  • Report this Comment On July 27, 2009, at 1:00 AM, knighttof3 wrote:

    A small suggestion, you can use it free of cost, my gift to you.

    Don't call it "asset location", call it "asset placement".

    No way a casual reader like me won't confuse location with allocation.

  • Report this Comment On July 28, 2009, at 2:49 PM, dbwood wrote:

    If you believe that a Roth IRA will be forever tax-frre, then you have not witnessed the history of how Congress can change its mind (remember tax-free limited partnerships?). When the government needs money, all the Roth IRA accounts will be a great temptation for raiding.

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