Taxes? Time to Stop Reading This Post …
Wait! Don’t leave. I promise not to bore you too much with a bunch of technical jargon.
Just know this:
- This can be beneficial to your finances in the future.
Why do I think that?
Consider this:
Everyone always thinks that your 401k and IRA are the only way to go when it comes to saving for the future. While both are great, remember that no matter what setup you choose you will ultimately pay taxes on them. These are called ordinary income taxes. If you’re a regular middle class guy like me, then your ordinary income tax rate is probably 25%.
- If you have a traditional setup, you’ll pay them later when you retire.
- If you have a Roth setup, you’ll pay them now.
While both are certainly a benefit, if you plan to retire early (like me) before age 59-1/2, then you’re going to need some portion of your money to not be locked up in prison. You’ll need to be able to access it. You’ll need a regular taxable account.
But here’s where the beauty comes in: Not all types of taxable accounts are the same. Some investments are better than others.
Tax Advantages on Dividend Income:
As a dividend stock investor I’ve known and appreciated for some time that if I receive income from my dividend stocks, I could enjoy a lower tax rate (around 15% instead of 25%). These would be called qualified dividends.
So my strategy for sometime has been this: Build up a nice pool of dividend stocks and simply live off the dividend income. Aside from a number of other great benefits, I was in love with the tax advantage.
But the problem is that you always pay taxes no matter what because dividend income (regardless of what you do with it) is “income”. So I’d still be on the hook for the 15% with all the income I receive.
How a Long Term Capital Gain Can Help Lower Your Taxes:
For some reason I had not explored too deeply the tax rates on other types of investments besides dividend income. I was pleased to learn that long-term capital gains had their own set of wonderful tax breaks as well.
Basically if I were to buy a share of stock (for now let’s pretend it’s NOT a dividend paying stock) and hold it over one year:
- It would qualify as a long term capital gain.
- I’d owe 15% instead of 25% in taxes on however much it increased by (i.e. the gain)
So this gives me yet another tool to use for my early retirement strategy besides just dividend stock investing!
But wait! There’s more:
- You only pay the long term capital gains tax when you actually sell the stock! That’s great news for a long-term investor like myself. It means I’ll be able to pay no taxes for quite some time as long as I hold on to my investments. This is different from having to pay 15% every time I receive dividend income. Example: Let’s say I buy a group of stocks at $10,000. Five years from now the stocks have increased to $20,000 and I finally decide to sell them. I’d pay the 15% capital gains taxes in that fifth year, and not during years 1-4. So by holding on to them for five years, I was able to defer my tax payments. When you compare this to a traditional IRA where you will eventually pay 25% on your gains, there can be some pretty lucrative and beneficial reasons to having some of your money in these types of accounts.
A Great Tax Resource:
If this is all too confusing or you’d simply like a great resource on this topic, I’ve come to learn that Fidelity has an outstanding tax guide that pretty much spells all this out. In addition to defining all these terms in more detail, the post also includes some easy to follow tables that clearly show you which bracket you’d be for the current year. It’s a valuable reference tool that I’m sure I’ll be coming back to for years to come.
Readers – How do you use long term capital gains to your advantage? Does anyone else have any useful tax tricks to lower their overall annual bill?
Related Posts:
1) When Can I Retire – It All Depends On How Badly You Want To!
2) Exploring My 401k Alternatives – Maybe More Dividend Stocks?
3) Who is the Best IRA Provider When You Don’t Have Much Money to Open an Account?
Image courtesy of FreeDigitalPhotos.net
Another thought for someone like you is that in your early retirement years, your income might not be as high as it is now because you won’t have a day job. So while today’s dividends are taxable on top of your regular income, tomorrow’s capital gains might be able to fill up some of the lower brackets and not be taxed at all. In an extreme example, if your only income for your early retirement years is in the form of long term capital gains, a big chunk of that won’t be taxed at all because you will have your standard deduction (or itemized) and the 10-15% tax brackets.
Every situation is different, but tax-efficiency is a huge part of investing that definitely gets overlooked.
Good advice. And even though I don’t want to think about it, I’m afraid I won’t have very much income (compared to what I make now) during those early retirement years unless I can save a boat load before hand. So hooray for low taxes, but too bad for my income. But that’s okay. The goal is to retire early, not be filthy rich.
The more I look into it there are a lot of benefits to choosing the right tax efficiency for your income. I wonder if there is a way to structure your income so that you don’t pay any taxes whatsoever.
Honest question here, and maybe I’m just ignorant, but I think you might have it wrong….
Don’t you pay the 15% rate on dividends each year you receive them?
In other words, if you invest $10k and in year 1 get $200 in dividends, that $200 is taxed at a 15% rate, even if you reinvest it, etc. Ditto dividends in year 2, 3, 4, etc.
Then, when you sell, the whole total gain is taxed at 15% for capital gains.
Am I completely wrong here?
Chadnudj,
That was kind of my point. Long term capital gains would be nice because you wouldn’t have to pay any taxes until you redeem them. This would be different from dividend income where you would pay taxes on everything you receive; regardless of what you plan to do with it.
I apologize for not explaining myself very well. I don’t think I made that very clear in my text, so I just went back and updated it.
It exactly this thinking that drives Warren Buffett to not declare any dividends, but instead reinvest all Berkshire’s income at a higher rate than you can get in an index fund. If you own a Berkshire share for ten years or more, you get the ultimate tax benefit, because he reinvests all your dividends tax-free to you.
And that’s why he has such a large number of individual investors who own Berkies for decades.
Although I like getting dividend payments, if there’s one person I’d trust to do a better job re-investing them than myself, it would be Warren Buffett. I’d take whatever decision he makes over some 3% return any day. Knowing him it probably works out to a 15 to 20% net return!
I’m totes down with paying taxes later on as many investments as possible. That is one reason I love the Roth. The only issue is if we become so broke around here that all the tax rates have to go up. That would be a bummer.
I had considered that … Personally I think there would be a lot of public backlash if the Government ever tried to tax what we’ve already been taxed on (i.e. a Roth).
I think I might be pretty dumb if I’d never started reading financial blogs. It wasn’t planned,but our house flip will profit will be taxed as long term capital gain when it finally sells because it’s taken forever. I guess that’s one bright side to an otherwise frustrating experience.
That sounds a heck of lot better than declaring it as a short term gain and paying a lot more. I know it seems frustrating, but the nice thing here is that you’ve learned a valuable lesson and will probably strongly consider this the next time you make a real estate transaction. I know I have to think about this every time I consider selling a company stock. There’s no need to erode my returns just because I didn’t plan correctly.
I am a bit hesitant investing in non-paying stocks for the long run. With those stocks you will be stuck with price fluctuation at the time of withdrawal so that is not too reliable source of income to me. I like dividends better, because if the company doesn’t change (cut or halt) the dividend, you will be receiving your payments indefinitely no matter what the stock is doing. So then the tax is an inevitable evil which needs to be accounted for in your retirement planning.
I think if I were to pick any kind of stock, it would be a dividend paying one from a strong prospect company. But I have not given up on considering bonds or balanced mutual funds to provide some diversification and stability to my portfolio.
For me to invest in a company that doesn’t pay dividends would require some really, really strong reasons. A good example of this was when I bought shares of Apple years ago (before they started paying a dividend). You had to be a fool not to recognize how profitable, cash-strong, and trendy this company was. And the stock performance that followed reflected that. Like all stock purchases, I eventually re-evaluated my position and got out at just the right the time.