Many of you are aware that I have been a big fan of tax-deferred investing over the past three – four years. After my awakening moment in late 2012/early 2013, I have been maxing out any tax-deferred account I could get my hands on. This includes my 401k, Roth IRA, SEP IRA and Health Savings Account (H S A). These moves have allowed me to:
1) Obtain substantial tax benefits upfront, allowing me to essentially purchase more stock for the same amount of money I would have invested through taxable accounts
2) The ability to compound capital tax-free for decades into the future
3) The ability to manage taxes in a way where tax expense is minimized when I do access that money
4) Obtain an employer match on funds contributed to a 401 (k) plan.
I have bought funds in my 401 (k) and HSA plans, and individual dividend stocks in my IRA, SEP IRA, Roth IRA accounts. As I max out those tax-deferred vehicles, I end up saving my whole salary, and essentially live off my dividend income and side income I generate. As a result, my tax deferred savings as a percentage of investable assets are increasing, and will be increasing over time.
Over time, I have kept reading and learning about the pros and cons of different accounts. As I get closer to the coveted dividend crossover point however, I am becoming more risk averse. I am trying to protect myself from low probability risks, which could have a wipe-out effect on my net worth. At this stage of the game, I am becoming more and more interested in asset preservation. It is my belief that once I am close to my “enough” point, I should be in wealth preservation mode.
In the process of researching things, I realized that there are benefits to a 401 (k) plan, versus a regular IRA. One of the largest benefits of a 401 (k) is the ability to protect assets from creditors and lawsuits. IRA’s also provide some protections, depending on the state where you live in. But 401 (k) plans provide a higher level of protection against creditors and lawsuits because they are viewed by courts as employer sponsored plans (somewhat similar to pensions).
A retirement plan such as the 401(k) is protected against lawsuits and bankruptcy. IRAs on the other hand are only protected against bankruptcy up to $1.17 million. Some states have a much lower limit of protection on IRA assets.
The downside of 401 (k) plans is that they have limited options for where to put your money. In my case, I only have a few index funds that have really low expense ratios. For example, the Large Cap S&P 500 Index Fund costs 0.02% per year. There is an international stock market index that costs about the same, while the small/midcap fund costs 0.10%/year. A bond fund costs 0.05%. It is possible that the plan will be able to provide participants to invest in individual stocks through the brokerage window at some point in the future, as more companies are allowing this feature. But this could be several years down the road from here.
After doing some research, I have decided to move most of my assets in the Roth IRA, SEP IRA, Rollover IRA into my company 401 (k) plan. This means that I will be selling a lot of my individual stocks held there. I may possibly end up keeping a token amount, in an effort to reduce account closing costs. The companies ones in the taxable accounts will most likely be kept as is.
The selling will not trigger any tax liabilities, since I have the money in tax-deferred accounts. I would have to ask my plan providers to send me a check, that I would then have to forward to my 401 (k) plan provider. Some brokers will charge me a fee to close out an IRA account with them. Others will not charge me a fee if I do a partial transfer, and keep some assets. I plan to do the partial asset transfers where possible, and minimize fees on the transfers. I also may keep little money in some of those retirement accounts, since I will most likely contribute money on a go forward basis ( SEP IRA, or Roth IRA). But those contributions would likely be then transferred to the 401 (k) on a periodic basis.
This move will result in more liability reduction and increased asset protection for me down the road. As I enter wealth preservation mode, I want to make sure I am covered from all sorts of risks. This move will also make taxes easier, and less painful, when I have to do a backdoor Roth IRA strategy if my household income gets to be too high. A backdoor Roth IRA is a strategy where you contribute money to a non-deductible IRA, and immediately convert that money into a Roth IRA. This could trigger tax liabilities and cause headaches if I have any IRA/SEP IRA assets from before. So I want to avoid that.
A 401 (k) will also be helpful when I do the Roth Conversion Ladder at some point in the future. This is a strategy where I convert pre-tax money such as regular IRA contributions or regular 401 (k) contributions into Roth IRA money. Depending on my tax bracket, I may be able to make this conversion and pay zero dollars in the process. Currently, a married couple filing jointly with less than $20,000 in ordinary income can convert money tax free from a regular IRA into Roth. Even if they earn $75,000 in qualified dividend income coming from taxable accounts, they can still convert money tax-free due to their low tax bracket. Tax arbitrage is a pretty neat trick, because I have avoided paying a 25% marginal tax rate on pre-tax contributions in the accumulation phase.
Based on the research I have done, it looks like the Roth Conversion Ladder will be challenging if I have money sitting in taxable IRA’s. By challenging, I mean the involvement of crazy gorilla math, which is something I will try to avoid at all costs.
Based on my research, the 401 (k) plan also has more flexibility in accessing money than IRA accounts. For example, I can take a loan from the money. I can also begin penalty free withdrawals at age of 55 rather than 59 and 1/2 for the IRA. Of course, my plan is to have everything converted to Roth by my late 50s. If I manage to pull this off, I will be able to never pay taxes again on distributions from my Roth 401 (k). If tax laws do not change materially, and I have managed to convert money to Roth, whoever inherits the money will not have to pay taxes on them as well. If current tax laws stay in tact, I would also be able to never pay taxes on qualified dividend income. But given the fact that I am contributing so much to tax deferred accounts, it is quite possible that the lion’s share of dividend income 20 – 30 years from now will be generated in tax-deferred accounts. If that is the case indeed by the 2040s, it is quite possible that my family’s social security benefits may not be taxable either.
If on the other hand I fail to convert all my money from pre-tax to Roth, all is not lost however. According to current rules, as long as I am employed in the company I have my 401 (k) plan in, I am not subject to the Required Minimum Distribution rules even if I am older than 70. This is valid, as long as I do not own more than 5% of my employer. This is a neat trick, which few employees seem to be aware of.
Since most of the money from those retirement accounts is in equities, I will allocate the equities money as followed 80% S&P/Small Midcap and 20% international stocks. My new contributions to my 401 (k) however will be 80% equities and 20% fixed income. For the equity portion, I am striving for a roughly 50% of the total contribution going to S&P 500, 15% – 16% going into an international fund and the rest going to a small cap/mid cap fund.
If my 401 (k) ever allows for investments in individual companies, I would change those asset allocations from funds to individual stocks. It is also possible that my next 401 (k) provider allows participants to build their own portfolios by selected their own individual dividend paying stocks for example. I had thought about this issue a few years ago. You may enjoy this article that discusses how to convert a portfolio of index funds to dividend stocks.
This move will temporarily reduce my forward dividend income. I would essentially move the money into the 401 (k) pool. This would mean that a portion of my total portfolio will be in index funds today. I will likely do a large portion of my future investing through my 401 (k) plans. While I do not talk a lot about what I do in my own portfolio, I am writing this in order to be more transparent with you and in order to be helpful to someone else with this article. As I have discussed before, I am essentially following both methods discussed previously in the article on how to accumulate a nest egg. I am essentially owning individual stocks in my taxable accounts, and funds in my 401 (k) plans. After years of saving and investing, this formula will bring financial independence to the participant.
The trade-off of increased asset protection for less investment options is worth it to with me at this stage of the game for that portion of my total portfolio. I am fine selling off some dividend stocks in retirement accounts that have appreciated a lot, which have not grown earnings for several years. Their valuations are high. S&P 500 is high too, and earnings are scheduled to decline. International stocks seem cheaper, but their earnings are less stable. I am increasing my fixed income allocation, just so I have some exposure to an asset class that would do well if we get deflation.
I have sent out my updated dividend portfolio to subscribers of my email list. I have not made up my mind 100% on this, but there is a chance that I will no longer provide updates to this portfolio on a go forward basis. Based on my observations, many investors spend more time looking at a list of portfolio holdings, and not enough time trying to understand the process of how and why this portfolio was assembled in the first place. This is a mistake in my book, which I may have encouraged by sharing the list in the first place.
I will keep holding on to my taxable dividend paying stocks. Selling them would be a dumb move, since I have a lot of unrealized gains. The rest of dividends will be generated in tax-deferred accounts. As I have mentioned before, I am living off my taxable dividend and interest income in 2016. I am also covering any gaps by side income. I am saving all of my income in my 401 (k) and HSA. I am also maxing out my Roth IRA and contributing to a SEP IRA.
I am still on track to reach financial independence by late 2018. However, this is more of a goal for me. It doesn’t mean I would do what everyone else has done and quit employment. I like where I am today, and if I like where I am in 2018, I may not make a lot of changes.
As I have hinted before, financial independence is important for me because it provides intangibles such as freedom, peace of mind and options in life. It is very likely that I will keep working my whole life, but at my own terms. As a result, I may end up working even harder than ever.
I consider myself to be extremely lucky, because I was able to achieve everything because I was born at the right time. If I was born a decade or two earlier, I would have never accomplished what I have achieved today. I also want to thank all of you for your support and encouragement, because many of you have been instrumental in helping me along my journey.
And why have I been talking about taxes so much? This is an extremely boring topic to begin with.
I am doing this, because I am inspired by the following Warren Buffett quote: “I don’t look to jump over 7-foot bars: I look around for 1-foot bars that I can step over.”
This means that Buffett is trying to focus on slam-dunk investments, where the odds of success are high, and there is some margin of safety.
I believe that by following the rules and maxing out tax-deferred accounts, the investor takes advantage of strategies that let them end up with more money, by maintaining the same level of risk. When you are incentivized with tax credits to invest a certain way, it is a no brainer to use that account type.