Over the last couple of weeks, I have had an internal debate on my approach to tracking dividends–and we have discussed it in some of the comments.
Initially, when I started this blog and created a focused dividend portfolio, I only referenced the dividends generated from my new purchases–as well as a couple of long-standing holdings in Apple, Abbott, and AbbVie.
Over time, I introduced the dividends from my core retirement accounts that are invested in index funds into my dividend income report. I had also included the self-made REIT ETF that I created with the funds from my pension rollover.
Ultimately, I decided to include all sources of dividends as part of my report.
However, as I have been giving a lot of thought recently to my early retirement draw-down strategy, I have come to a realization. While I don’t anticipate that this will change my approach to tracking at this time, it is something that I need to recognize.
That realization is that not all dividends are created equal.
Source of Inequality
When I say that not all dividends are created equal, what I mean is that as one strives towards the goal of early retirement, the ability to leverage those dividends to cover all, or a portion of, your living expenses is dependent on your age and the type of account where those dividends are generated.
My personal FIRE (Financially Independent Retired Early) goal is to step away from my current career at the age of 52.
During my younger years, I focused on maximizing my tax-advantaged accounts such as my employer’s 401(k) account and a Traditional IRA for myself and DivvyMom.
As the years progressed, our ability to contribute to a Traditional IRA and then a Roth IRA disappeared due to the modified adjusted gross income (MAGI) limits. Obviously that is not such a terrible problem, however there was one glaring hole in our strategy.
We did not funnel additional savings into a taxable brokerage account.
Unfortunately I have not met anyone that has a time machine, and therefore my reluctance / fear / ignorance (take your pick) of investing in a brokerage account due to the tax implications resulted in a lost opportunity.
It wasn’t until 2011 that brokers had a responsibility to begin tracking your cost-basis on shares purchased and dividends that were reinvested. Therefore, rather than buckle down and ensure that I was maintaining detailed records, I foolishly ignored making investments in my brokerage account.
Why is that important in relation to FIRE?
Well, as you may know, your ability to access tax-advantaged funds before the age 59.5 is limited. There are strategies to mitigate that, and I won’t go into a lot of detail here but will try to summarize them, including some of the challenges.
- Roth Conversion Ladder :: The concept is to transition funds in a 401(k) to a Traditional IRA, or simply start with your Traditional IRA, and then convert them over to your Roth IRA. It is most advantageous to do this after you’ve stopped working as that minimizes the tax impact as you can convert up to $24,000 under the standard deduction for married couples filing jointly.
The converted funds cannot be accessed for 5 years, and that is part of the problem. If you start this process once you’ve stopped working to reduce the tax impact, you will need an alternate source of funds–typically a brokerage account or cash–to cover the gap until you can begin withdrawing those funds. All of this assumes you’ve retired before the age of 59.5 as well.
- Substantially Equal Periodic Payment (SEPP) :: This option allows you to withdraw funds from an IRA or 401(k) prior to the age of 59.5 without incurring the early withdrawal penalties. While this can address the issue of having a gap between your early retirement date and the age of 59.5, there is one drawback in my opinion.
First, you must withdraw the same amount every year and those funds are placed into an SEPP plan that pays you an annual distribution.That annual distribution is required for five years or until you turn 59.5, whichever comes later. With my goal to retire at 52, that means that I would need to withdraw funds for 7-8 years, which is longer than I would need based on current taxable investments and cash available to cover our expenses.
- Rule of 55 :: The IRS Rule of 55 allows an you to withdraw money from your employer 401(k) plan between the ages of 55 and 59.5 without penalty as long as it is only from the 401(k) where you were employed up to or after you turn 55. This sounds like an attractive option, however there is one issue based on my scenario.
As I plan to leave the workforce at the age of 52, I will have left my employer before the age of 55 and therefore would be unable to take advantage of this option. Therefore I would need to either adjust my plan and continue working until the age of 55, or find a job in semi-retirement that provides a 401(k) and rollover my primary 401(k) into that new account (and still continue working until the age of 55).
- Withdraw and Take 10% Penalty :: As I have been investigating my draw-down strategy, I have read a few articles that propose the fact that it may not be as negative as one thinks to take early withdrawals from your tax-advantaged accounts and simply pay the 10% penalty for doing so.
Off the cuff, this would be the least attractive option to me as I don’t like the idea of being penalized with a tax for utilizing the funds that I’ve saved for my retirement.
Alright, let’s pull this back to the discussion about dividends and how they are not all created equal.
When I initiated my dividend portfolio, my thought process was to utilize the dividends once we reach the age of retirement to supplement our income and allow us to take a more conservative approach to our safe withdrawal rate.
Being late to the game–at least in terms of dividends from a taxable account, because as mentioned above, all of the dividends in my tax-advantaged accounts are not readily available until age 59.5–let’s see what that would look like as of today.
Total Dividends vs. Accessible Dividends
You may recall from my more recent dividend income reports that I have included the dividends received from tax-advantaged accounts in addition to those from my taxable account.
Unfortunately that presents a more optimistic view of the dividends that will be available to me than what is my current reality for the early years of retirement, unless of course I leverage one of the options above.
As you can see here, the portion of my total investment portfolio that pay dividends currently generates $15,625 annually.
With approximately 10 years left to go until my targeted retirement date, that would provide a number of years for me to continue growing that amount. Based on current projections, assuming that I made no additional contributions and using the overall growth rate of all dividends, that would be approximately $23,000 to $25,000 in annual dividends in 10 years.
Given that I will be continuing to invest new capital, that amount should actually turn out to be considerably higher.
However, there is one big problem.
Not all of those dividends are accessible to me in the early years of retirement.
Without utilizing one of the options previously discussed, I would be limited to accessing the dividends only from my taxable account. That means even the dividends from my REIT ETF, which are in a Rollover IRA, are off-limits.
So what does that look like?
My taxable brokerage account currently produces only $3,317 in annual dividends. That is quite a different picture than thinking that I have over $15,000 in annual dividends readily accessible to help cover our expenses in retirement, or at least the early years of retirement.
This all might be old hat for you, but as I’ve been digging into draw-down strategies and beginning to formulate my own plan, it has been a bit of a “light-bulb” moment for me.
I’ve been so laser focused on simply accumulating enough assets that will provide for a comfortable and early retirement, I haven’t been paying as much attention to how we will access those funds to actually cover our expenses until we reach the age of 59.5.
Make Every Dollar Count
As my friend’s over at Dividend Diplomats regularly remind their readers, over the next 10 years I really need to focus on making every dollar count.
To bridge the gap between our early retirement age and when we can begin drawing from our tax-advantaged accounts, I want to continue focusing on being as aggressive as possible to fund my taxable account and continue feeding this dividend machine.
What might that look like?
The above forecast from Simply Safe Dividends uses the current numbers from my taxable portfolio. Assuming that there are no further contributions and my average 5-year dividend growth rate remained stable, I would be projected to have $9,430 in annual dividends from my taxable account in 10 years.
While that might be great, that isn’t going to go very far in early retirement.
However, as I mentioned, I definitely will not be sitting idle and will continue to deploy new capital as often as possible.
My initial goal has been to create $20,000 in annual dividends, which if I include all investment sources is a slam dunk. However, I am revising that goal to create this amount purely from my taxable account.
Is that realistic?
Let’s run some back-of-the-envelope math to see what I think should be realistic.
Taking a look at the last few months of progress, on average I have increased my projected annual dividend income by $191.10 each month. On an annual basis that would be $2,293.16, and with approximately 10 years until my targeted retirement I would be looking at roughly $22,931.60 in annual dividends.
Add to that the $3,317 that I am earning today, and I would have $26,248.60 in annual dividend income at the age of 52.
That’s not too shabby.
However, as I would anticipate having $40,000+ in annual dividend income from all investment sources, you can see just how important it can be as to the source of those dividends and how those can be utilized in early retirement.
Pulling It All Together
Hopefully this hasn’t been too scattered and you now (or already did) understand what I meant when I said that not all dividends are created equal, at least as they pertain to being an income source in the early years of retirement.
I have only scratched the surface of researching and educating myself on an appropriate draw-down strategy for once we retire.
However, I am extremely grateful that I have started down this path now as it has opened my eyes to the importance of looking beyond the accumulation phase that I am so engrossed in right now.
Hindsight is 20/20 and all of the shoulda / coulda / woulda’s cannot change the mistakes that I have made in the past–and believe me, I have made my fair share.
However none of that will change the fact that I will continue working as hard as possible to fund my dividend portfolio and grow a substantial dividend snowball that we can play with in early retirement.
As I close this out, I will note that for the time being I am not planning to change the tracking in my spreadsheet but will definitely continue to separate out the sources of dividend income in my monthly reports. This may change as I move forward, but I have setup my portfolio in Simply Safe Dividends to track by source for now.
If you’re still with me, thank you for reading!
I would love to hear your feedback, as well as your thoughts surrounding your draw-down strategy if you’re planning to retire early.