Are your stocks paying a special dividend to avoid taxes?

I hope you enjoyed my recent series of articles on net worth. I’ll definitely revisit the topic in the future. But right now, I wanted to address something else that has been happening recently.

An interesting phenomenon is happening. Many companies are paying special dividends as the year comes to a close. In fact, I just saw an article where the Washington Post Co. is planning to pay it’s entire 2013 dividends on December 27, 2012. Some but not all companies are paying an extra dividend.

The companies that are doing this are trying to hedge the risk of Congress not reaching a deal over the so-called “fiscal cliff” and thus seeing tax rates go up on January 1st. This especially extends to taxes on dividends. Right now, unsheltered dividend income is taxed at 15%. If nothing happens, then it will go back to up to the owner’s regular income tax rates next year.

What does this mean for a long term dividend investor?

I’m definitely one of them, even if stocks aren’t a majority of my investment portfolio. How am I prepared for these new tax rates? Well, I have rebuilt my investment portfolio to be tax smart.

  • Most of my stocks are inside a Roth IRA, meaning any dividends I receive are not taxed.
  • I have units of an MLP in a non-tax sheltered account. MLP dividends are mostly tax free and don’t benefit from IRA shelters.
  • Real estate depreciation doesn’t appear to be on the table, and most of my depreciation only shields rental income.
  • And I haven’t heard anyone talk about adjusting tax laws in regards to EIUL policies, so that is secure for now.

This means I have things structured so that most of my wealth building won’t be impacted heavily by these daily headlines.

I used to invest in mutual funds wrapped in a 401K and also had some stocks, but I didn’t really know what I was doing, because I didn’t take an active role in researching things. If you pulled me over and asked me what my long term wealth plans were, it wasn’t more than, “throw money into my 401K.” On rare occasion I looked at the stocks that I owned and made changes, but not many.

Now I monitor things much more closely. I only have five stocks, which means I can keep track of them. None of them appear to paying a special dividend, but I’m watching for any announcements.

Bottom line

Essentially, my biggest exposure is going to be any rising income tax rates and social security tax rates on my active income from my job. If you read The Millionaire Next Door, one key thing that is pointed out is that most millionaires don’t earn a $1 million/year, but instead have a net worth exceeding $1 million. Most of these millionaires aren’t high income earners like doctors and lawyers. This lets them duck the high marginal tax rates while building business equity, real estate holdings, and strong stock portfolios.

So what changes do I have in mind if taxes go up next year? Not many. I would normally be concerned if one of my stocks decided to stop paying dividends. One of my key criteria in stock selection is to pick one that not only has a history of paying dividends but also of increasing the dividends every year. If one of my stocks decided to pay all of its 2013 dividends in the next couple of weeks, I will keep an eye on it, to see if they resume regular payments in 2014. If they put on the brakes, then I will do more research at that time to see whether to keep it, or close my position and hunt for a replacement.

While Apple has started paying dividends, I don’t treat it the same way. I bought it for appreciation. Berkshire Hathaway doesn’t pay any dividends so it isn’t subject to the new dividend tax rates either. Both of these positions are based on the long historical growth they have exhibited, and the fact that they aren’t my at the top of my wealth building plan. Is your wealth building plan setup to take some knocks? Send me a message and we can talk about it.

Advice based on risk but not net worth doesn’t cut it

I was listening to a radio show recently, and the caller was debating with the host the fact that while he held mutual funds, he had also invested in stocks over the last 10 years. Given that I have been writing several articles about net worth lately, I felt particularly attuned to the lack of attention to net worth. When the host asked how much he had in savings, the caller answered $96,000. When he next asked how much he had in the stocks, the answer was $47,000.

The host immediately went on the war path. He slammed the caller for having a broken risk meter. He asked the caller if he really thought he was going to “beat the odds.” He told him he was playing with fire. The fact that the caller had bought some tobacco stocks because people haven’t stopped smoking was dismissed as a frivolous strategy. The host indicated he probably knew more about stock investing than the caller, and that he flat out didn’t hold any single stocks. The call kind of ended there. I was a bit stunned!

Can you spot the rights and wrongs amidst all this?

First of all, the focus of the host was all about risk. The fact that the caller’s total net worth was just shy of $100,000 never entered the foray of discussion. The host chewed him out for buying stocks (making good on-the-air schtick), but didn’t get on his case for simply not saving enough. The Federal Reserve bulletin which comes out every three years shows that the average person in their mid 50s has around less than $60,000 in retirement savings (page 28), which is way low for building a retirement plan. The caller was a little better, but not much. Considering he had been investing in stocks for at least 10 years means the caller must at least be in his mid-30s. The fact that his net worth was way low for a good retirement was flat out not covered. The caller doesn’t seem to understand the truth about net worth and the reason we need to build up a portfolio of performing assets.

From there, the conversation went downhill. The host of the show berated his caller for basing stock buying decisions on what products are commonly used. The caller clearly knows that tobacco products aren’t going away anytime soon. In fact, the most successful investors of our day, including Warren Buffet and Ben Graham, preach that we should only buy companies we truly understand. If you look at all the products you use for your morning routine, you may spot things that millions of other people are using every morning as well. This leads to some potential stocks that deserve additional research and analysis to consider for purchase. While the host was correct that study after study shows people can’t beat the averages in day trading, buy-and-hold over the long term has been shown to succeed and build wealth, if you know what you are doing. As Warren Buffett says, “I buy on the assumption that they could close the market the next day and not reopen it for five years.”
The host said this guy had too much in stocks. That is something I agreed with. But the host implied that the answer was mutual funds. People buying mutual funds have a long term average performance of less than 4% annual growth. Not good enough! This caller needs something with a better, long term, double digit growth factor. The answer is investment real estate. It allows us to use safe amounts of leverage while taking advantage of some of the best tax laws on the books. Over the long run, real estate typically has a better appreciation rate than stocks. But don’t base your analysis of a piece of rental property on appreciation. Instead, base it on no appreciation and no increases in rent. If it’s in a good location and built with good quality, then you may be closing in on an opportunity. The less deferred and potential maintenance the better.
I’m sure if the caller had mentioned the idea of real estate backed by debt, the host would have shot that down in a heartbeat as risky and especially dumb when debt is brought into the picture. There definitely is risk involved, but that’s not reason to drop the whole idea. Instead, we need adequate cash reserves to mitigate this risk. There WILL be vacancies, repairs, and other costs to deal with, all which require a certain amount of easy-to-reach cash. Assuming Murphy will make an appearance and planning to deal with that will let you sleep at night.
The fact that the host was driven by risk and didn’t discuss net worth tells me he is imbuing his callers with a fear-based investment strategy. “Go for mutual funds. They are your best tradeoff because they let your money grow faster than CDs yet protect you from the total brunt of market corrections.” Okay, the host didn’t say that, but he might as well have. Fear isn’t enough to build a retirement plan. The diversity of mutual funds may protect you from certain losses, but even worse, they also protect you from recoveries even more.
In the math of losses and gains, you need gains bigger than your losses to get back to where you started. 20% loss requires 25% recovery to get back to where you started. 50% loss, 100% gain. We call that stacking the deck against you! Instead of wasting your time searching for the right mutual fund, find someone who is skilled at pursuing rental property and has a proven track record of building net worth for their clients. That is something that will, in wealth building lingo, cut it.

Apple (AAPL) and General Dynamics (GD) declare dividends

Apple (AAPL)

Earlier this month, Apple made a dividend payment of $2.65 per share, generating a 1.7% or $10.60 annual dividend yield. This is a part of their plan to distribute $2.5 billion (that’s billion with a “B”) to shareholders every 3 months. If you didn’t catch that, they are paying out $2.5 billion EVERY QUARTER.

They have indicated they also plan to use some of their cash to initiate buying back stock. As with any company, this has historically caused stock prices to rise, with less shares being available. Companies in strong financial positions can do this to increase the price as well as increase the interest others have in the stock, both positive things to do when the company is strong. They also indicate they will have plenty of cash after all this to still continue product development and valuable acquisitions.

Over the next three years, their combination of dividend payouts and stock buybacks is estimated to total $45 billion in cash.

It’s important to note that when I purchased Apple stock, I had not planned on buying it as a dividend performing stock, but instead hoping it would continue it’s long path of growth. If I was seeking dividends, I wouldn’t have bought such an expensive stock that had such a low yield. I say this because I don’t want anyone to think I am endorsing Apple as a strong dividend paying stock.

I admit it’s a bit of a gamble, but I run on the assumption that people will want to keep buying their products. Things like the iPod, the iPhone, and the iPad have been incredibly successful and altered the market of consumer devices. In the software development circles that I run, the Apple Macintosh laptop and desktop computers are very popular, at least amongst software developers. I started watching Apple stock months ago, and only wish I would have started sooner. Given all that and their historical growth, I believe their stock price will continue to grow surely and steadily. The fact that they passed Exxon last year as the biggest company ever ($607 billion market value) helps out as well.

General Dynamics (GD)

On August 9th, General Dynamics paid out a regular quarterly dividend of $0.51 per share, resulting in a $2.04 or 3.2% dividend yield. This is good news, because they are keeping up with their previous dividend payouts. I happen to have already received a payout relatively soon after I bought my first position and I first posted about GD, so it was nice to receive more cash to eventually invest in more shares. I am planning to accumulate more dividend holdings before deciding which of my current stocks to invest it in.

To buy or not to buy…

As dividend payouts build up in my account, I have a decision to face: invest immediately to get more of the action, or wait a few quarters and do this once-a-year. If I invested every dividend payout as they occurred, that might put the money back into action faster, but I would be forced to possibly pay more broker fees. For now, it seems better to save up all the dividends and consider doing that once a year, and definitely when prices are at their best levels.

This is another benefit of long term dividend stock investing: there is no rush so I’m not forced into buying at a bad price. I can wait a year, two years, or even more, until I’m comfortable with the price and yield to continue my position. Though I do hope it won’t be two years before I see one of my holdings showing a good position to increase.

Finally, if you plan to purchase any stocks of your own, don’t just buy what I’m buying. Perform your own analysis, understand the company and its products, and make an informed choice.

Disclosure: Long AAPL, Long GD

Buying Vanguard National Resources (VNR)

Last week, I bought a position in Vanguard Natural Resources LLC (VNR). VNR is a master-limited partnership. MLPs in the United States are involved in transporting and storing a limited set of commodities, particular petroleum and other natural resources like natural gas. Basically, MLPs build and run pipelines for critical energy products used across the country.

MLPs are required to pay out a high rate of its cash flows as dividends in order to avoid paying corporate income taxes at the federal and state level. There are some other benefits involving depreciation that I won’t go into here. They aren’t effective when bought inside tax deferred plans like Roth IRAs, which is why I bought it in my tax exposed account. Just be sure to check if your CPA knows how to properly handle this when filing your tax returns.

If you haven’t gleaned this yet, MLPs have a higher payout than typical stocks. Looking at Yahoo, VNR’s current dividend yield is 8.40% ($2.40/share per year). It has an attractive P/E ratio of 7.50. Combined with a purchase price of $27.49, it makes a nice and affordable equity. Add to it that most if not all dividend payouts will be tax free (until you finally sell the stock, which is hopefully never), and you got yourself a sweet investment in my book to eventually draw retirement income from years from now.

VNR has recently announced their plans to shift from quarterly dividend payouts to monthly payouts in a few months. There aren’t many stocks that pay out monthly dividends. Imagine the convenience of building up a nice position to draw dividends upon in retirement. For the record, I decided on picking VNR before this was announced, but was pleased to hear such an announcement.

The other criteria I employed before picking VNR was the fact that it has been increasing it’s dividend payouts for several years. It is nowhere near being a dividend aristocrat or dividend king yet. In fact, it has only engaged in increasing its dividends for five years. For some, this may be a critical factor with five years being too short. In this case, I decided to take a chance. If they shift their dividend payout strategy in the future, I can sell my position and shift it to another MLP. There are many to choose from.

By all means, feel free to read my analysis and use it to create your own investment criteria, but don’t just buy VNR because I did.

Disclosure: Long VNR

Tell tale facts about mutual funds

Are you invested in mutual funds? The likely answer is yes. That’s because Wall Street has very successfully pitched mutual funds inside 401K wrappers as the primary means of retirement savings for at least 30 years. This is despite some astonishing information about mutual fund providers.

Did you know that there is over $12 trillion invested in mutual funds? That doesn’t indicate the success or failure of mutual funds, only the magnitude of the situation at hand. After all, there is a lot of money invested in cash value life insurance. Many top executives at large companies provide over funded life insurance policies to their executives as part of their compensation package. At the same time, some of the companies have their salespeople preaching “buy term and invest the difference.”

The average salary for a mutual fund manager is $240,000/year. I have no quarrel with someone making a good salary, since I applaud successful entrepreneurs being rewarded for their efforts and choices. But where this really starts to lose ground is the fact that 15% of these directors stay in the business for 20 years or more. They come back, year after year, and keep managing funds, whether or not they did well. You see, their measurement on how well they do isn’t 100% based on how well you or I do. A significant factor is whether or not they made good sales. Did they keep enough clients from the previous year, or in turn, gather enough new clients. Either way, if the fund itself takes a nose dive, it shouldn’t be an assumption that the fund manager gets fired. If that were true, the turnover would be huge.

61% of mutual funds have lagged the S&P 500 over the past five years. This is where Wall Street’s message of “find a financial investor” gets spelled out crystal clear. In one breath they say, “odds are against you picking a mutual fund that will succeed. You need an advisor.” And then the next thing they say is, “but we can pick a good mutual fund. The odds are NOT against us.” The odds cut both ways. If you are looking at hiring a financial advisor, ask for a listing of every client he or she has had for the past 10 years, and their overall performance.

Let me say that again: ask for their client’s performance. If your potential advisor tries to tell you the 10-year performance of the funds he or she suggested, don’t accept it. You aren’t evaluating whether the fund works. You are evaluating whether his clients succeeded using him.

Another tragic fact of mutual fund companies is that most of the oversight controls are in house. They may have a separate board in charge of oversight that doesn’t directly pick the funds, but this is still under one roof. Now we may look at people like Warren Buffett and Berkshire Hathaway and try to ask, “what is the difference?” After all, Warren Buffet and his board essentially decide what to buy and sell. They own either in part or entirety, over 70 companies.

What’s the difference? A huge one. Berkshire Hathaway has annual shareholder meetings and have votes. Shareholders can vote out board members, even Warren Buffett himself, if they aren’t doing their due diligence. Past members of the board have left due to various differences. This bodes for true accountability to the shareholder. Mutual funds don’t have shareholder meetings. There are not votes. The board put in place makes all the decisions, and the company board overseeing them don’t answer to you either. They are on the hook to answer to the SEC, but when is the last time that the SEC prevented a major fiscal disaster?

Another major difference between mutual funds and owning the same equity in Berkshire Hathaway is what happens when people want to dump their holdings. When you own a mutual fund, you don’t really own stock. Instead you own shares in a fish bowl of equity. When you ask for your piece, they must empty out the fish bowl. Due to their strategy of investing, they may be forced to sell lots of stuff, good and bad, to pay you out. When a lot of people dump their holdings due to a downturn, they have to cash out a lot and take bad losses. It is hard for them to simply sell the most profitable stuff and allow you to share in the good fortune. That’s because a huge portion of the equity of a mutual fund is kept in stocks and bonds (or whatever else they are investing in). Very little is kept in liquid cash.

When you sell a chunk of Berkshire Hathaway, you aren’t asking Warren Buffett to unload any stock. Instead, you are asking another investor to buy your shares at whatever the current trading price is. There is no middle man in this respect the way there is in a mutual fund. Maybe they picked up some bad stocks, maybe their good, but your panicky nature during a downturn doesn’t directly force Warren Buffett to unload good stocks just to meet your liquid needs.

Does any of this sound like the stuff you heard the last time you chatted with a professional mutual fund advisor? I didn’t think so.

To sum things up, mutual funds have been very profitable for the companies. That is probably why the managers can keep their jobs. It should be a tell tale sign that when mutual fund companies keep the same people for decades, their lack of ability to police costs and serve your needs not of serious concern. Actively investing in your own strategies and seeking out products that meet your wealth building needs requires constant, active research on your end. Handing this off to someone tilted towards merely finding the “best” mutual fund for you won’t cut it.

I am not a licensed financial advisor nor an insurance agent, and cannot give out financial advice. This is strictly wealth building opinion and should be treated as such.

Rebalancing my portfolio – part 2

I already mentioned the first step in rebalancing my portfolio: replacing my 401k with an EIUL. My second step is investing in some dividend aristocrats and holding onto them FOREVER, pulling in dividends and reinvesting them for the long term.

What’ll you take – dividends or appreciation?

There are a few stocks that have been paying dividends for over 20 years. And not only that, they have increased their dividend payments each year. It’s not that hard to find them. Better than that, some go back over 50 years in paying increasing dividends, each and every year. These are sometimes referred to as blue chip stocks.

There are a couple of ways to make money off of stocks. Either you buy low and sell high (we call that appreciation), or you buy and hold, waiting for dividends payments to come in. By taking the dividend route, you can buy more shares with the dividends and grow your capital, further increasing dividends payments. The longer you stretch this out, the less you are worried about the appreciation of your stock.

People have made a living out of predicting the rise and fall of stocks. They are called fund managers, and they consistently underperform the market indices. They try to guess (yes, I said guess) when the stock will be low and buy it, and try to predict the high to sell. Do you know what happens when they are wrong? Nothing! In 2008 a LOT of mutual funds increased their fees because so many people were pulling out of mutual funds.

When you pick some blue chip stocks that have stood the test of time, you aren’t gambling on appreciation. Instead, you are investing in the power of the company.

Only buy companies you know

Notice how I said investing in the power of the company? That is because you shouldn’t buy stock in companies you don’t know a thing about. Just because a whole gaggle of people are diving into something (Facebook’s IPO anyone?), doesn’t mean you are catching the low. Often when you follow the news, you are late to the game.

Did I mention dividends? Yes, that is the main thrust of this part of my plan, but there is someone out there who HAS stood the test of time in picking stocks: Warren Buffet. That’s why when I got my first dividend payout, I bought one share of Berkshire Hathaway B (BRKB). He has averaged double the market for the past 40 years. No one else has come close. His stock doesn’t pay dividends, but he definitely knows how to grow stock value.

The tax man cometh

No investment strategy can be complete without considering taxes. Since the government has a huge appetite, you need to figure out how you are going to make as much as possible while being strategic in how much you get to keep (like how I couched, ehh?).

One option is to buy in an open account. That means you are buying with after-tax money, and any gains are subject to the tax laws of the day. They will tax you on any gains when you sell as well as any dividends you are paid. Over time, this can eat up your returns.

In my previous article, I mentioned that using a Roth IRA shouldn’t be your primary vehicle for retirement savings. I mean that. Roth IRAs limit you to putting away $5000 a year, and that just isn’t enough for a comfortable retirement. But it doesn’t mean you shouldn’t take advantage of what you CAN put in there. That is why this is just a part of my long term plan (you’ll have to wait for part 3).

There is an old adage: would you pay taxes on a bag of a seeds or on the yield of the field where you planted? In many forums, I have seen people comment that if your tax brackets are identical at the beginning and the end, then it doesn’t matter whether you pay now or later. That is absolutely true. And…very unlikely.

When someone suggests that when I retire I shouldn’t worry about tax rates because I will have less needs, then that smells like someone is setting me up for a rough landing. I would prefer to work towards having MORE when I retire than I have now. Then, deciding what to do with the extra money will become a nice problem to have. That is better than deciding which shift to work at Walmart because I didn’t save enough!

So, if I set things up to pay taxes as I approach retirement, I could either pay less taxes or pay more, based on what direction the government takes. That sounds REALLY risky. I would rather take my knocks now, and then be tax free at retirement.

Think about it: does the government want the taxes from your $100,000 today, or would they prefer to tax your $250,000 that you built up as you enter retirement? As Dave Shafer says, you don’t think the government invented IRAs and 401Ks to reduce their revenue stream do you?

Of course, I have heard the argument made that you should take every tax discount you can now. Waiting until retirement to find that they have changed the tax code and plan to tax you on both ends is a risk of its own. I can appreciate that, because how many times has the government changed it’s mind when it comes to tax codes? This is what you might call caught in their cross hairs. My crystal all is as cracked as yours, but I’m going to gamble that taxing on both ends of a Roth is much LESS likely than tax rates being HIGHER when I retire.

What I bought

So after pouring over historical reports, spreadsheet data, and a little self speculation, here is what I have bought.

  • General Dynamics (GD) – they have a history of paying increasing dividends over 20 years, while currently sporting a 2.88% dividend yield. On April 11th, they announced a $0.51/share dividend. I believe that the need for military aircraft isn’t going to diminish anytime soon.
  • Chevron (CVX) – they have been paying increasing dividends for over 24 years, while showing a dividend yield of 3.34%. They are one of the Big Oil companies. Because this planet is going to be running primarily on oil for the next century, I believe this is not only a good investment, but a good hedge against inflation.
  • Apple (AAPL) – they don’t have a consistent history on paying dividends, but have a long history of consistent growth. This is one of those I-think-people-will-keep-buying-their-stuff feelings. They actually reached a point where they have too much cash and not a clear idea on what to do next. Sounds like a nice problem to me.
  • Berkshire Hathaway B (BRKB) – this is another non-dividend payer, but there is a 40-year history of growing bigger than the market. Heck, they hardly ever do a stock split. The only reason this one split recently had to do with a particular company they had acquired. Other than that, I expect this one to keep growing.
Beyond these four, I don’t feel compelled to buy any other companies at this point in time. That may sound crazy, but did you know that the theory of diversification asserted that owning more than 30 companies produced a diminishing set of returns? When you own some mutual fund that has dozens of stocks, if not hundreds, there is no way for you to analyze it. You are totally in the hands of the fund manager, and their track record isn’t good.
I originally started with General Dynamics, Chevron, and Apple, but just received my first dividend payment. I thought owning a piece of Warren Buffet would probably be good for me, so I got underway. From here on, you can see how things perform as I continue blogging. Please show me where the TV personalities are blogging about which mutual funds they own.
Please don’t just buy what I buy. Do your own research and decide for yourself what you’re comfortable with.

Disclosure: Long on GD, CVX, AAPL, and BRKB.

Cross posted from

I am not a licensed financial advisor nor an insurance agent, and cannot give out financial advice. This is strictly wealth building opinion and should be treated as such.