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Dividend Reinvesting vs. IRA investing (tax treatment)

unaided

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I wanted to vet this idea with the forum. I know that readers of MJ are not in the save, slave and retire frame of mind. You build your wealth with a value-laden business that makes CENTS - and you use the market to maintain your wealth, and provide some 5% interest to live from, and you sit on cash to say "F U" to the slowlane and pay cash when opportunities come up or to avoid BS.

(Hey! BTW tax advice is very individualized, so follow a plan that's best for you, I'm not a tax advisor and don't play one on TV, and replies to this are not tax advice, and laws can change by the time you read this, do your own homework)

IRA:

You pay taxes at least once on this money. Roth, you pay your tax now, let's say 30% for state and federal. Traditional, you pay later...potentially 30-40% federal/state tax bracket. You're paying taxes on a higher amount because of the tax-free compounding. Overall, depending on where you are in your tax brackets, Let's say that net over net, money in an IRA will provide a 10+% net advantage depending your normal bracket.

Dividends:

You pay regular income tax on unqualified dividends and capital gains at 30-40% depending your tax treatment, and then generally 20% tax on qualified dividends. Still generally a 10% net advantage?

If you reinvest dividends and wait to pull them as income, from my understanding this is not taxed until you actually sell the reinvested principle. So if you don't plan on withdrawing principle unless you're taking significant gains or rebalancing at good reasons.

Doesn't long-term reinvested dividends wash out with the benefits of an IRA from a tax perspective? Except you can use the principle/ dividends at no penalty today vs. waiting until you're 59.5 years old?

You're still paying tax one way, and I tend to believe that with social security, medicaid, obamacare, student loan bailouts, car loan bailouts, that for my generation (I'm 32 going on 33 years old) taxes will be the same, or higher 20-30 years from now (or inflation will be higher which is usually answered with higher interest rates on dividend income/higher value of dividend-producing assets). Even if I make more, my write-offs may be more in terms of what is actually claimed, so I'm not counting on a higher tax rate either as per Roth treatment.

Am I missing something obvious with my analysis that they are essentailly a wash with one another? I figure this group would be the best to offer their critiques.
 

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CareCPA

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You still had to earn the money (and pay tax on it) to invest in the stocks that pay dividends.

Say you have an extra $15,000 to play with, and you're averaging 30% in income taxes. You can put it either in the Roth (subject to limits) or brokerage stocks. Either way, you're going to pay the $4,500 in tax when you earned it, so net you're investing $10,500. If you invest in dividend-paying stock in a brokerage account, then you're going to pay tax on the dividends, and capital gains when you sell. If you have it in the Roth, you can invest in the same stocks, but not pay any taxes on the dividends or capital gains when you withdraw it as long as you're of the correct age (under current tax law).

Traditional vs Roth just has too many moving parts to be able to accurately analyze on the internet.
 
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unaided

unaided

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Thanks for your reply.

So let's call pot A = IRA and pot B = taxable brokerage account

$15,000, net $10,500 invested.

pot A = tax free dividends (until drawn as income) - at income tax table - ~30% (possibly 5-10% cheaper depending on Roth or IRA treatment)
Pot B = taxed dividends - at 20% when "qualified"
= reinvested dividends - (tax-free until the shares purchased by reinvested dividends are actually sold?)

So the wrinkle that I'm asking...

You buy and reinvest dividends until some future time when you decide to take on the dividends as cashflow. When you take the dividends as cashflow - they are given lower tax treatment than the standard income tax tables.

1.) you never have to take on capital gains if you don't want
2.) you can use this money today penalty-free vs. 59.5 years old.
3.) The "risk" is that when you occasionally want to take capital gains (such as MJ's "3 years in 3 months" rule) - you will pay taxes that otherwise could be saved and further compounded in a retirement.

When you automatically reinvest the dividends in a taxable brokerage account, do you still claim taxes on them the year they are earned, or the year that the reinvested shares of stocks are actually sold?

Example $100 for 1 share in stock A produces $5 in dividends a year, but reinvested, Now you own 1.02 shares of stock A worth $105 and producing $5.25 in dividends a year.

If you take the $5 as income, you pay ~20% on taxes, if you reinvest it, you don't pay taxes until you sell the extra 0.02 shares you own, right? So what if you never sell the shares, but just decide whether you are reinvesting dividends or taking them as income.

Doesn't this beat a retirement account in that:

1.) you still get preferred tax treatment (without guessing what tax rate will be 20-30 years from now) 2.) you can still choose to take dividends as income (taxed at lower rate) and choose not to take capital gains IF you're focused more on cashflow vs. growth.

Maybe there's some bold assumptions here but that's why I wanted to present it to this group.
If I have an extra $10,000, I can use that money today to make $500 a year in dividends, put it against debt, or turn it into equity, and get preferred tax treatment for doing so.

If I put it in an IRA, I'm sealing my fate of being forced to be "scripted" until I'm at least 59.5 years old, and I'm still guessing that my tax rate will be lower/higher depending on Roth/Traditional treatment.

Any thoughts on these wrinkles?
 

CareCPA

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[cut for brevity]...
You buy and reinvest dividends until some future time when you decide to take on the dividends as cashflow. When you take the dividends as cashflow - they are given lower tax treatment than the standard income tax tables.

1.) you never have to take on capital gains if you don't want
2.) you can use this money today penalty-free vs. 59.5 years old.
3.) The "risk" is that when you occasionally want to take capital gains (such as MJ's "3 years in 3 months" rule) - you will pay taxes that otherwise could be saved and further compounded in a retirement.

When you automatically reinvest the dividends in a taxable brokerage account, do you still claim taxes on them the year they are earned, or the year that the reinvested shares of stocks are actually sold?
[...]
You pay taxes on the dividends when they are earned, whether you reinvest them or cash them out.
 
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unaided

unaided

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Okay, that's what I needed to clarify.

So let's fast-forward to 59.5 and I want to take the IRA dividends/capital gains as income, I no longer get preferred tax treatment for long-term, qualified dividends/capital gains correct? That cuts 10-15% of the benefit despite the extra compounding.

The "reward" being that you're paying on a hypothetically much larger number despite potentially paying as much as 10-15% more in taxes. For instance, if account is 200%+ higher from compounding, paying an extra 10-15% on it may be moot point.

I guess I'm trying to evaluate the net risk of not doing so vs. having the money be liquid as you need it. (Business reinvestment/real estate investment vs. Paycheck income vs. F' you income)

  • Real estate capital gains and rental income have tax-free benefits when certain criteria are met (lived in home 2 out of 5 years, held it for at least 2 years & less than $250,000 in capital gains, 1031 exchange etc). My wife is also a realtor.
  • Reinvestment of the same funds into a business and the potential growth/compounding/write-offs rates on that money far exceeding the use of that money in a retirement that you can use earlier than retirement, having spouse/kids work for you at fair rates.

  • Still flush out retirement accounts once all debt is taken care of, (SEP, & Traditional) to shelter excess earnings, (...when those excess earnings exist).

    Wouldn't these essentially trump IRA investing? I guess it all 'depends'
 

CareCPA

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Here is my generic tax advice.

If you're in a high tax bracket (i.e. 35%), and you plan to be in a lower tax bracket in retirement (i.e 12% under current law), the arbitrage of socking money away now to use in retirement can work in your favor.
If you plan to be in a similar tax bracket, it may not make sense to lock it up in an IRA if you have a more productive use for it. My bigger concern is people not putting money in retirement accounts, and also not investing in other income and wealth generating assets.

Real estate is a great tax shelter. Small businesses are great tax shelters. 401k/IRA accounts are usually one of the few tax shelters available to a W-2 employee that has neither a business nor real estate.
 
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unaided

unaided

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Thanks for your feedback. Yes, I take windfalls/savings and pump them into a business or cash system, but I understand the concern with non-fastlaners.

Ultimately, you would take advantage of all of them, but I'm still in a growth stage where I'm just now getting extra money to put into various outlets and so this really helped solidify my own understandings/priorities.
 

JScott

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The point you seem to miss in the example above is that if you earn $15,000 and invest it into a traditional IRA, you are investing $15,000 (you defer taxes). If you are investing into another investment, you pay taxes on the income before you invest -- so you're investing closer to $10,000 - $12,500, most likely.

If both of those investments double, the IRA is now worth $30,000 (and you owe taxes on the entire amount); the other investment is worth $20,000 - $25,000 (and you taxes on the dividends along the way and the final gain).

Which is a better way to go will depend on your personal tax situation...
 

biophase

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Here is my generic tax advice.

Real estate is a great tax shelter. Small businesses are great tax shelters.
Can you expand on this?

Maybe I’m missing something or maybe I’m just phased out due to income on REI.

As for small businesses, can you explain this further?
 

CareCPA

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Can you expand on this?

Maybe I’m missing something or maybe I’m just phased out due to income on REI.

As for small businesses, can you explain this further?
Sure thing.

There are a couple different ways to look at this.
The traditional viewpoint:
- With a small business, you can put away up to $53,000 a year into a 401k, instead of the employee-max of $18,000 with a regular job.
- For real estate, depreciation shields most of your cash income (which I think this is a false point, you're paying for the basis that is being depreciated, it isn't just some magical deduction the government gives you).
- Advanced: If you're in a high-income bracket (say 35%), consider setting up a C Corp for a business that you can separate out (i.e. your coaching business). Marginal C Corp rates are only 15% up to $50,000 in profit. Keep the money in for a rainy day, or dividend it out when you're having a down year.

The viewpoint I like better is more long term, but requires flexibility.
- For real estate, what if you start with a small building, and keep 1031 exchanging into larger buildings? Say you start with a single 100,000 rental, and by the time you're 70 you have $5 million in apartment buildings. You've never paid tax on the disposals along the way, because you keep utilizing the 1031 exchange rules to kick it down the road. Then you die. Now your kids get the stepped up basis of $5 million, so the taxes on the gains you would have recognized if you sold are never paid. Even better, they can begin depreciation this $5 million dollar basis, even though the properties were depreciated by you before death. Repeat for generations, own the world.
- What if you didn't have to draw a salary from your business? Say you start a C Corp. You bite the bullet and pay tax at the C Corp level, but you decide you don't need a salary. After 5-10 years (or whenever), you decide to sell it. Since you've held the stock long-term, the business sale is a long-term capital gain. This would work for any business structure, but there is some appeal to it not flowing through onto your tax return each year (i.e. you can harvest gains from other accounts, take advantage of tax credits intended for lower incomes, etc).
What if you have no other businesses going on, so you don't have any other income on your tax return? Then you can spread the sale out over years, and keep filling up the 0% capital gains bucket with C Corp stock sale gains.
Even better, if your C Corp is a qualified small business, you can potentially exclude up to $10 million in gains anyway, no need to spread it out over time.
 

JScott

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Real estate is a great tax shelter.
Just to clarify...

Buy and hold real estate is a great tax shelter.

Most other real estate investing activities -- flipping houses, wholesaling, lending, etc. -- are very poor tax shelters.
 

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biophase

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The traditional viewpoint:
- With a small business, you can put away up to $53,000 a year into a 401k, instead of the employee-max of $18,000 with a regular job.
Do you mean a SEP IRA here?

- For real estate, depreciation shields most of your cash income (which I think this is a false point, you're paying for the basis that is being depreciated, it isn't just some magical deduction the government gives you).

- Advanced: If you're in a high-income bracket (say 35%), consider setting up a C Corp for a business that you can separate out (i.e. your coaching business). Marginal C Corp rates are only 15% up to $50,000 in profit. Keep the money in for a rainy day, or dividend it out when you're having a down year.

The viewpoint I like better is more long term, but requires flexibility.
- For real estate, what if you start with a small building, and keep 1031 exchanging into larger buildings? Say you start with a single 100,000 rental, and by the time you're 70 you have $5 million in apartment buildings. You've never paid tax on the disposals along the way, because you keep utilizing the 1031 exchange rules to kick it down the road. Then you die. Now your kids get the stepped up basis of $5 million, so the taxes on the gains you would have recognized if you sold are never paid. Even better, they can begin depreciation this $5 million dollar basis, even though the properties were depreciated by you before death. Repeat for generations, own the world.
- What if you didn't have to draw a salary from your business? Say you start a C Corp. You bite the bullet and pay tax at the C Corp level, but you decide you don't need a salary. After 5-10 years (or whenever), you decide to sell it. Since you've held the stock long-term, the business sale is a long-term capital gain. This would work for any business structure, but there is some appeal to it not flowing through onto your tax return each year (i.e. you can harvest gains from other accounts, take advantage of tax credits intended for lower incomes, etc).
What if you have no other businesses going on, so you don't have any other income on your tax return? Then you can spread the sale out over years, and keep filling up the 0% capital gains bucket with C Corp stock sale gains.
Even better, if your C Corp is a qualified small business, you can potentially exclude up to $10 million in gains anyway, no need to spread it out over time.
Thanks I'll need to digest this for a few days.

On the business sale, the cash in the company goes with the sale so that is at long term capital gains? Is that what you are saying?

I just sold my company, most of the sale is taxed at capital gains. The only stuff taxed at ordinary income is inventory. Are you saying that if the company had $1,000,000 in cash, because I sold the stock of my company that the $1,000,000 that I never took out personally becomes taxed as cap gains, because my business just sold for $1,000,000 more?
 

CareCPA

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Do you mean a SEP IRA here?
There are a couple different options depending on your business structure and whether or not you have employees. I always point people to the Vanguard page here, since they summarize it more succinctly than I could.

I just sold my company, most of the sale is taxed at capital gains. The only stuff taxed at ordinary income is inventory. Are you saying that if the company had $1,000,000 in cash, because I sold the stock of my company that the $1,000,000 that I never took out personally becomes taxed as cap gains, because my business just sold for $1,000,000 more?
It all depends on how you structure the sale, and the type of entity you are. I'm assuming you were an S Corp, so the sale could have either been structured as an asset sale or a stock sale (if you're selling an entire business, and not just a product line within the business). I'm guessing the buyer structured it as an asset sale (which is more beneficial to them, as they then get cost basis in the inventory and any assets), and your lawyer/accountant didn't fight them on it.
If you had structured it as a stock sale, it would have been just like selling GE or Apple. The amount of cash they hold on the balance sheet has no effect on how your gain is treated if you sell their stock.
 

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