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.

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