Last year I wrote a post about how I was thinking about diverting some of the money we were contributing to our 403b retirement fund towards our dividend stocks instead.
This was somewhat of a controversial move because traditional personal finance advice is to invest in your tax-sheltered accounts, not your taxable accounts! After all, why would you want to save your money in an account where you have to pay taxes?
But it wasn’t that simple. There were several more alluring reasons why investing in dividend stocks would make more sense:
- I was getting better returns from our dividend stocks than I was from our 403b funds. The 403b funds were only getting an average of 5 to 6% returns whereas the dividend stocks were more on par to get 8 to 9% returns.
- The dividend stocks were much cheaper. 10 transactions a year at $8 only costs $80, whereas the average expense ratio of our mutual funds is over 1%. On $100K, that’s over $1K.
- And the most important factor: The prospect of being able to retire early …
Dividend Stocks Can Help You Retire Early:
That last point was by far the most important. After working out the numbers on my early retirement financial freedom plan, I saw a BIG opportunity to increase the chances of having an adequate amount of money to bridge the years between early retirement and Age 59-1/2 (when you can access your 401k, IRA, etc). And that opportunity lied with getting more aggressive at building up my dividend stock portfolio.
The interesting thing about using dividend stocks for retirement is this:
- If you build up enough dividend funds, the 3 to 5% dividend yield you stand to make off of them could result in a steady stream of stable income.
- If you pick the right companies (the ones that haven’t decreased their dividend payments in over 25 years), then the share price becomes somewhat irrelevant. All you need to do is just hold the shares of the stock.
So ultimately I did end up lowering the amount of money we contribute to our 403b plan and diverted it over to our brokerage fund with the intentions of buying more dividend stocks. Over the course of a year, this should give me about $5,000 extra to spend when I make my next big purchase.
This brings me to my current dilemma: Should I do the same thing with my 401k fund? Should I explore more 401k alternatives that will help me retire early?
Exploring Dividend Stocks as One of My 401k Alternatives:
The pros and cons of diverting more money into my dividend stock fund instead of my 401k are not quite as clear cut as they were with the 403b. Here’s a few of the things I’ve been tossing back and forth in my head:
- By diverting even more money over to my taxable account, I’d have potentially even more money to fund my early retirement.
- But then again I’d also stand to not make as much money due to tax erosion from being in a taxable account.
- However, dividends and long-term capital gains are generally taxed at a lower rate than traditional ordinary income which is what your 401k would be taxed as. For example, I may pay only 15% as opposed to 25% or higher.
- Eventually you HAVE to pay taxes on your 401k income.
- The employer match threshold on my 401k is only up to 8%. I’m currently contributing the full $17,500 per year, so I’m a long ways away from endangering my employer match.
So let me ask you, my Readers: Who else would try this? Would you trust your 401k or put more faith in your dividend stock portfolio? What other 401k alternatives or unconventional methods have you explored to achieve your financial goals?
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I think there’s a case to be made for investing outside of your 401k, but I personally wouldn’t focus only on dividend stocks. I understand the reasons why people are excited about dividend stocks, especially in the past few years, but a total return approach makes more sense to me, especially in a taxable account. Not only are you more diversified, with greater opportunity for different types of returns, but capital gains represent deferred taxation while dividends do not.
I’m not sure I’ve ever heard of anyone talk about a Total Return Approach before. Is this what you are referring to?
https://www.forbes.com/sites/greggfisher/2011/11/14/beyond-income-investing-a-total-return-approach-to-funding-your-retirement/
Seems like an interesting way to promote longevity in your portfolio …
Yes that is what I’m talking about. Dividends are only part of the equation when it comes to stock returns, with capital gains actually being the higher-returning factor (though also the riskier factor). By focusing only on dividends, you are not only going to lack diversification in terms of companies and sectors invested in, but you are lacking diversification in terms of source of returns. As an investor, beyond tax characteristics you shouldn’t care where your returns come from, so there’s no inherent reason to prefer dividends to capital gains. And especially in a taxable account, dividends can be draining because they are taxed annually, while capital gains can be deferred.
There may (emphasize the may) be an argument for a higher allocation to dividend stocks when you are actually in retirement, though I wouldn’t personally subscribe to that. But especially when you are accumulating, it doesn’t make much sense to focus on only one source of returns. Diversification is your friend.
I’ll have to go back and read that article again. Maybe I’m over-generalizing, but isn’t that simply just a buy and hold strategy of a diverse group of assets? That’s okay if it is because unlike a lot of other PF bloggers I personally find nothing wrong with a buy and hold mentality; essentially that’s what you’re doing when you own an index fund or anything else that just trails the market over long periods of time.
I completely agree that diversification is very important in any long term strategy. Over Christmas my eye caught the title of “The Little Book that Still Saves Your Assets” and I bought a copy. The author made a very compelling argument for why class and sector diversification was critical. It really opened my eyes as to how NOT diversified I really am.
I should caveat my intentions with the dividend stocks: My focus is really on to use them to bridge the years between early retirement (we’ll say age 45) and when I can touch my 401k without penalty (age 59-1/2). This is all documented but marginally outdated in this post here:
https://www.mymoneydesign.com/personal-finance-2/retirement/money-design-achieving-financial-freedom-nov-12/
The number one attraction is income generation without penalty. Yes taxes will have to be paid. But the dividends will produce solid returns. Plus using the Dividend Aristocrats where the dividends rarely go down, I will have some level of confidence that my payments will not decrease; regardless of share price. As long as I own how ever many shares, I will collect that level of payment.
Several responses to this. Sorry ahead of time for the length.
I personally use index funds because I believe it’s the smartest way to invest, but you can utilize a total return approach without index funds. Probably the prime example is PIMCO’s total return bond fund (PTTRX), which just so happens to be the biggest mutual fund in the world.
I will say that I have no problem with someone trying to live off dividends. If they generate enough income for you, then great! Rock on and enjoy life. I just don’t think it’s the most efficient way to invest because you’re focusing only on one source of returns and ignoring another. Most people will have to save much more money by focusing only on dividend stocks then if they diversify more broadly. And the tax-efficiency argument is a real one. You might choose not to care about it, but annual taxation loses you money compared to deferring it.
Also understand that with these Dividend Aristocrats, you’re not talking about a secret sauce. This strategy and these stocks are well known, so all of the advantages and disadvantages are already priced in. This means that you’re essentially making a choice along the risk-return spectrum to choose less volatile stocks at the expense of a lower expected return. There’s nothing inherently wrong with that, but the same risk-return balance could be struck with a simple stock-bond split utilizing total-market index funds that increase your diversification. I don’t know this for a fact, but I would venture a guess that you could actually have a higher expected return for the same level of risk because of that increased diversification.
Also, these dividend aristocrats are not some kind of special company that never fails. According to Wikipedia (the most trustworthy source in the world!) there were 52 of these companies in 2009 and there are 51 today. But 14 of those companies are different. That’s more than a 25% turnover in just 4 years! Is that really the stability that you’re looking for with this strategy?
So my view on dividend strategies is that you’re giving up return and diversification for a decrease in risk that could more effectively be achieved in other ways. There’s no inherent reason to prefer dividends to capital gains, except for volatility, which can be mitigated by other parts of your portfolio.
Hope this is helpful. Feel free to email me directly if you want to discuss this further: matt at momanddadmoney dot com.
Your passion for this strategy is very intriguing! I went online and read up on it a little more. I’ve got a good idea that I will email you about.
This is how I went about it: I don’t need the dividends until I actually retire. So until that day, I maxed out my tax-benefited accounts (401k and IRAs). In our 401k we simply picked index funds, because the selection is always so limited. In our IRAs we picked a mix of dividend paying stocks and growth stocks.
Now that we’re retired, all the 401k money was rolled over into IRAs. And those are partially allocated to dividend stocks and the other part is still in stocks we hope will grow enough to where we can sell them to get more dividend stocks than we could buy now. It may work, it may not — we’ll see 🙂
Thanks William. Unfortunately however my early retirement situation requires that I adequately fund taxable accounts that I can touch before Age 59-1/2 without penalty.
This is exactly the reason why I maintain taxable account too – early retiremnt. All my other tax defered account allow you to take money out when you reach 59 1/2 of age, but what if you want to retire at 40? Although not my case anymore, I wish to get out of the rat race before 50. Then the taxable accounts will overcome that period.
Exactly! That is my goal, and I perceive dividend income as one of those income streams that can help me retire early.
I worry about stability most of all. As we saw in 2008, nothing is truly secure.
As someone who watched his portfolio get cut in half during the worst of the Great Recession, I especially worry about stability. Although nothing with a great return is ever guaranteed, I do believe that some choices are better or more practical than others. This is why I concentrate on mostly large cap, cash rich companies. There may be a lot of other good prospects out there, but I feel more comfortable putting the big boys to work for me.
Dividend stocks interest me more than other investing options. As soon as I am ready to start investing I think I’ll be back for some help 🙂
That sounds good to me! There will be plenty of posts and links to other resources ready and waiting to help.
I love the idea of dividend stocks, and that’s something we’ll likely do when we have a bit more cash freed up. Sounds like a great source of passive income to me.
They are Laurie. Though I don’t have a ton of dividend stocks yet, I can clearly see the early retirement potential in owning them and the income they could generate for me.
You and I have pretty much the exact same perspective on this, but I’m not sure if this is the right move or not. One interesting angle I heard someone talking about was that taxes are unrealistically low currently and are nearly certain to be going up over the next few decades. If true, then it could be wise to pay your tax now while it’s low vs. deferring and paying a higher rate later.
This is essentially the logic behind a Roth, but it really depends on your marginal rate now vs. what you think your effective rate will be later. What I mean by that is if you defer taxes now, you save money at your marginal rate. But later when it’s withdrawn, it’s not all taxed at the margin. Some is taxed in lower brackets, making your effective rate on those withdrawals much lower than your marginal rate at that point in time. That’s a big difference that needs to be considered as part of the equation.
The Finance Buff wrote a good take on this: https://thefinancebuff.com/case-against-roth-401k.html
Matt,
What do you think the likelihood is that lawmakers will go back on their word and tax Roth’s anyway someday? I know that sounds crazy. But earlier this year when a cap was proposed on how much retirement funds we could have in our 401k’s and IRA’s, I suddenly became very scared that we were on a very slippery slope that wouldn’t end well for savers like ourselves.
https://www.bloomberg.com/news/2013-04-15/retirement-account-cap-with-obama-budget-buoys-insurance.html
Thanks for the Fiance Buff link. I’m always interested to hear different and new points of view on the Traditional vs Roth topic.
I’ll start by saying that I ignore politics as much as I can. But while anything is possible, I doubt that we’ll see Roth’s taxed. The proposed cap simply limits future contributions. It doesn’t punish people who have already contributed, which is what taxing Roths would do. To me, those are very different things. You certainly never know, but my guess is that we won’t see it.
I really hope they never do. If they did, I could see a lot more retirees fleeing as quickly as possible to retire abroad.
Nick, you bring up a good and scary point. I saw a chart once of the “average tax rate” over the last 70 years and it blew my mind. I’m not totally convinced that most of us will continue the luxury of paying that good-ole average 25% for forever.
I have a low cost index fund that makes up my 401k. The investment choices that I have make it more prudent for me to go with this option. My aim is really not to do anything silly with this so as to not muck up the employer contribution that I get.
I have a much bigger taxable account with dividend stocks that is 4-5x the size that will get me early retirement (thats the hope any way!). Its not as tax efficient, but with a 15% dividend tax, its a small price to pay for early retirement optionality.
We have a very similar strategy, but I feel I am about ten years behind you on it. My 401k is also mostly simple, low cost funds that I use to maintain for stability in my portfolio. My taxable account is not anywhere as big, but I obviously see the benefits is concentrating some of wealth there in my early retirement attempt.
Direct stock purchase plans in solid companies that pay dividends are a good route to go. You can avoid a lot of the fees of a brokerage. I own a handful in addition to my other accounts for a little additional income. Some of them are so affordable that they do not have any trading costs at all or account opening fees.
Thanks Scott. I actually just found out that Fidelity account lets me DRIP my stocks. I’ll have an article coming out in about 1 week on the topic.