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Are You Costing Yourself 42%?

If you're a dividend investor, chances are you've been pretty aggravated this past year. Since the banking crisis started last September, dividend payments have been sliced and diced like veggies at a Japanese steakhouse. To make matters worse, a lot of the dividends that are still out there might not be sustainable.

The pain hasn't been limited by sector, either. In addition to cuts at major financial institutions like Goldman Sachs (NYSE: GS  ) and SunTrust Banks (NYSE: STI  ) , we've seen similar damage at companies like U.S. Steel (NYSE: X  ) and Pfizer (NYSE: PFE  ) .

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 around 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 increases (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 electronics behemoth Nokia (NYSE: NOK  ) , fast-food giant McDonald's (NYSE: MCD  ) , and industrial leader Caterpillar (NYSE: CAT  ) .

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 the money once -- when it gets taxed in his or her paycheck.

Investor B, on the other hand, gets taxed twice -- in his or her paycheck and on the 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 that initial $5,000 into a pretty nice sum. The $425,000 definitely won't be enough to retire on -- some estimates suggest you'll need $1 million to retire comfortably -- but it's a start.

Investor A, on the other hand, by holding his or her 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 members for more than five years now, and he has just added Fool fund guru Amanda Kish to his team. Together, they've built user-friendly model portfolios with specific recommendations tailored to your retirement-planning needs. Sound like something for you? 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.

This article was first published July 22, 2009. It has been updated.

Matt Trogdon owns stocks, but he doesn't own any of the ones mentioned in this article. Pfizer and Nokia are Motley Fool Inside Value recommendations. The Motley Fool has a tax-advantaged disclosure policy.


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