The Power of Investment Income

…through long term cap gains and dividends.¬†If earning $73,800 per year (married filing jointly) or $36900 (filing single) and PAYING NO TAXES interests you, then please do read on for an interesting story. I will explain why lots of financial independence(FI) bloggers use investment income as a vehicle for their FI journey.

Many years ago, I remember Warren Buffett mentioning that he pays a lower tax rate that his secretary. I never really figured out what he meant until I started exploring financial independence myself and started investing in stocks myself. To understand his statement, one needs to understand some part of the income tax code….I know, not a popular topic, but knowing a little bit of the tax code can save you lots of money in taxes!! So, bear with me.

Types of Income

There are many types of income a person can earn. Some types are listed below:

  • From working for somebody
    • Salary
  • From owning stocks and bonds
    • Long and short term capital gains
    • Dividend Income
  • From owning real estate
    • Rental income
    • REIT funds income
  • From cash
    • Interest income from banks

Types of Income according to IRS

The tax man has a different notion of income. The tax man sets the amount of taxes based on the different notions of income. So, let us understand the types of income a tax man sees.

  • Ordinary Income
    • Salary
    • Short term capital gains (from selling stock owned less than a year)
    • REIT income
  • Ordinary Dividend Income
    • Owning non-qualified stocks that pay a dividend
  • Qualified Dividend Income
    • Owning qualified stocks that pay a dividend
  • Long term Capital Gains
    • from selling stock owned more than a year

The simple definition of Qualified dividends means income from corporations that meet a specific criterion like incorporated in the US or in a country that has a tax treaty with the US, stocks owned more than 60 days prior to the ex-dividend date, etc etc. There is a link at the bottom of this article for details. But, dividends from most US corporations are Qualified dividends.

Tax Filing Status

The tax man also specifies a filing status based on the different social definitions attached to a person.

  • Single
  • Head of Household
  • Married
    • filing jointly
    • filing separately
  • Qualifying Widow or Widower

IRS Tax Rates for the types of Income

Since the tax man sees income differently than you and me see it and different filing status, the tax rates are different for the different types of income. For 2014, let us consider the following table for two of the most common filing status types.

Tax Rates Single Married Filing Jointly / Qualifying Widow or Widower
Ordinary Income Long Term Capital Gains and Qualified Dividends Taxable Income over to Taxable Income over to
10% 0% $0 $9,075 $0 $18,150
15% 0% 9,075 36,900 18,150 73,800
25% 15% 36,900 89,350 73,800 148,850
28% 15% 89,350 186,350 148,850 226,850
33% 15% 186,350 405,100 226,850 405,100
35% 15% 405,100 406,750 405,100 457,600
39.6% 20% 406,750 457,600

The most important rows to consider are the rows in BLUE color. Two things stand out in the blue rows

  • 0% tax rate for
    • Long term capital gains
    • Qualified dividends
  • 0% tax rate until…
    • $73800 for married filing jointly
    • $36900 for single filers

What the above powerful statements tell us is that if *ALL* of your income comes from long term cap gains OR from qualified dividend, you will pay ZILCH to the tax man i.e. you get to keep what you earn!! How beautiful is that!

Back to Warren Buffet and his secretary…

You did not think I forgot about him did you ūüôā According to some news articles, Warren¬†Buffet himself declares that he pays a 17.4 percent rate on taxable income. Note that he earns millions of dollars in income, but the first $73800 is tax free. His secretary apparently pays 8-9 points above him i.e. her average tax rate is atleast 25%. How is this possible? This is possible because of this:

  • Warren Buffett
    • most income is Investment income
    • Taxed at lower rates
    • First $73800 of investment income is tax free
  • His Secretary
    • most income is Salary income
    • Taxed at a much higher rate (from the table about, it is 25%)

Conclusion

Most financial independence bloggers, when they achieve financial independence and retire early, expect to get income from two sources

  • Stock investment
    • selling stocks and realizing long term capital gains
    • qualified dividend income
  • Rental income

If you are in the stocks category, like I am trying to be, aim for a good chunk of income from Investment income and get to keep all of the income until $73800 (married filing jointly) or $36900 (single filers).

It would be good to diversify the income streams and get some rental income as well. But, that is not my chosen path yet because of lack of hard $cash$.

Go Investment Income!!

Links

Money Stress…how I am trying to manage it.

I participated in a discussion on MMM forum today where a poster said the following:

More than 1 in 4 Americans report they feel stressed over money most or all of the time, and most say their stress over money has either remained about the same as last year (59%) or gotten worse (29%). http://www.latimes.com/science/la-sci-sn-stress-report-money-inequality-20150205-story.html

After reading the post and thinking about my own experiences, I realized that Uncertainty about the future is a big part of stress in any area…be it money stress, job stress, relationship stress or health stress. Unfortunately, I have been there, done that in all the areas I mentioned here. But, over time, I have managed to come to somewhat come to grips on each of them to varying extents. Today, I thought I will write about how I am handling¬†my Money stress as a way to help some folks and as a way to learn from some more folks.

In my mind, there are three kinds of money stress I have seen/been around/experienced.

Type 1: Stress about money decisions made in the past

Examples in this type of money stress are:

  • Bought a home in the peak of 2007 in a HCOL area (friend)
  • Did not buy a home in 2009-2011 (me)
  • Did not invest money when I was young….(me)

Type 2: Stress about money decisions of today

Examples in this type of money stress are:

  • How will I pay my bills this month? (me)
  • My car broke down..how can I pay for it?¬† (me)

Type 3: Stress about money decisions of the future

Examples in this type of money stress are:

  • How will I pay for retirement? (me)
  • How will I pay for my parent’s care? (friend)
  • Will I have a job in 3 months? (me)
  • Can I even buy a house? (me)

People can be in any of the above three OR all three. At many points in life, I have experienced the following combinations of money stress:

  • Type 1 only.
  • Type 1 and 2 only
  • Type 1 and 2 and 3

My attempts at overcoming Money Stress

But, as I have grown older and started chipping away towards FI, I have reached the following state of mind:

I am least stressed about Type 1

  • stress is not zero..but I have mostly come to peace with my past

I am about 30% stressed about Type 2

I am 70% stressed about Type 3

  • Figuring out what¬†financial independence means to me really really changed my life. It reduced a huge amount of Uncertainty on what the¬†financial future looks like for me and my family.
  • Putting a $ value to each goal helps me stay focussed.
  • Tracking my progress towards financial Independence¬†via this blog really helps in the following way:
    • reminds me of my goals pretty much every day.
    • reminds me to work hard to protect my current income.
    • reminds me to keep expenses as low as possible
  • Working towards Passive income streams before buying a house.
    • Sacrificing current desires for certainty about the future
  • Worry about smaller periods of time.
    • For example, if I only consider tomorrow, I have some worries. If I consider 1 year, my worries increase dramatically.

The Future

It has been a constant battle with money stress and basically uncertainty in life and I am sure that the battle is far from over. But, the above tips I have been practicing have helped me control the stress by slowly chipping away at the Uncertainties in my life…one chip at a time.

Hopefully, the above tips are helpful to others as well. Please share your own tips with me so that I can better my life by learning from your experiences.

Motivational Thoughts

Step by Step

<< I recently read a wonderful article from UConn.edu. I am reproducing it here verbatim since I thought it was extremely powerful. It lifted me out of my blues..hope it does the same to others as well. >>

The famous basketball player Michael Jordan wrote the following about goal setting in his book, I Can’t Accept Not Trying: Michael Jordan on the Pursuit of Excellence:

I approach everything step by step….I had always set short-term goals. As I look back, each one of the steps or successes led to the next one. When I got cut from the varsity team as a sophomore in high school, I learned something. I knew I never wanted to feel that bad again….So I set a goal of becoming a starter on the varsity. That‚Äôs what I focused on all summer. When I worked on my game, that‚Äôs what I thought about. When it happened, I set another goal, a reasonable, manageable goal that I could realistically achieve if I worked hard enough….I guess I approached it with the end in mind. I knew exactly where I wanted to go, and I focused on getting there. As I reached those goals, they built on one another. I gained a little confidence every time I came through.

…If [your goal is to become a doctor]…and you‚Äôre getting Cs in biology then the first thing you have to do is get Bs in biology and then As. You have to perfect the first step and then move on to chemistry or physics.

Take those small steps. Otherwise you’re opening yourself up to all kinds of frustration. Where would your confidence come from if the only measure of success was becoming a doctor? If you tried as hard as you could and didn’t become a doctor, would that mean your whole life was a failure? Of course not.

All those steps are like pieces of a puzzle. They all come together to form a picture….Not everyone is going to be the greatest….But you can still be considered a success….Step by step, I cant see any other way of accomplishing anything.

I Can’t Accept Not Trying: Michael Jordan on the Pursuit of Excellence is published by HarperSanFrancisco, a division of HarperCollinsPublishers (ISBN 0-06-25119)

VDIGX vs VTSMX: Which is a better investment?

VTSMX is a total market fund.¬†VDIGX is a Dividend Growth fund…primary a¬†large blend (value+growth) fund. In a recent discussion that I participated on MMM foum, I did some analysis on where VDIGX is w.r.t. VTSMX and learnt some new things. Based on that, the answer is: it depends ūüôā Hey, don’t try to kill me for this…I will try and justify my answer!

Is VTSMX (total market index) better than VDIGX?

1.

Comparing VDIGX vs VTSMX in Morningstar over a 10 year period, here is what I get when I plot the growth chart: Link. According to this chart, I see two wins for VDIGX:

  • VDIGX seems to outperform VTSMX
  • VDIGX seems to have a smaller loss than VTSMX in the 2008 downturn.

2.
Comparing VDIGX vs VTSMX in Morningstar over a 5 year period, here is what I get when I plot the growth chart: Link. According to this chart, I see one win for VTSMX:

  • VTSMX seems to outperform VDIGX

Note that this is a total return comparison for a fixed amount…i.e. total return == dividends+capital gains.

3.

Just to cross verify this result, I went to Vanguard site itself and compared the two funds. The above conclusions seem to hold up. In the last 3-5 yr range, VTSMX is better; in the last 10 yr range, VDIGX is better.

4.

Past performance is not a predictor of future performance, but Wellington family (VDIGX manager Don Kilbride comes from here) has a good reputation. So, assuming there is some meaning in past performance, here is what I see:

  • In the Bull market of last 5 years, VTSMX has performed much better.
  • In the market dip of 2008, VDIGX seems much better
  • In the dip+bull market over the last 10 years, VDIGX seems to come out ahead.

Is VDIGX a better fund for a taxable account than VTSMX?

Lets me see what the answer is to the second question of VDGIX/VTSMX for a taxable account. Coming down to brute force numbers, here is the dividend distribution for the last year.

VTSMX
Distribution    Most Recent
Type            Distribution    Record Date    Reinvest Date    Payable Date    Reinvest Price    Distribution Yield    SEC Yield
Dividend ¬†¬†¬†¬† ¬†$0.25800 ¬†¬†¬†12/18/2014 ¬†¬†¬†12/19/2014 ¬†¬†¬†12/22/2014 ¬†¬†¬†$51.75 ¬†¬†¬†‚ÄĒ ¬†¬†¬†1.76%¬† B
Dividend ¬†¬†¬†¬† ¬†$0.21100 ¬†¬†¬†09/22/2014 ¬†¬†¬†09/23/2014 ¬†¬†¬†09/24/2014 ¬†¬†¬†$49.58 ¬†¬†¬†‚ÄĒ ¬†¬†¬†‚ÄĒ
Dividend ¬†¬†¬†¬† ¬†$0.19000 ¬†¬†¬†06/20/2014 ¬†¬†¬†06/23/2014 ¬†¬†¬†06/24/2014 ¬†¬†¬†$49.49 ¬†¬†¬†‚ÄĒ ¬†¬†¬†‚ÄĒ
Dividend ¬†¬†¬†¬† ¬†$0.19200 ¬†¬†¬†03/21/2014 ¬†¬†¬†03/24/2014 ¬†¬†¬†03/25/2014 ¬†¬†¬†$47.08 ¬†¬†¬†‚ÄĒ ¬†¬†¬†‚ÄĒ
——–
$0.851
tax = $0.851 * 15% = $.12765

VDIGX
Distribution    Most Recent
Type                Distribution    Record Date    Reinvest Date    Payable Date    Reinvest Price    Distribution Yield    SEC Yield
Dividend ¬†¬†¬†¬† ¬† ¬† ¬† $0.21800 ¬†¬†¬†12/19/2014 ¬†¬†¬†12/22/2014 ¬†¬†¬†12/23/2014 ¬†¬†¬†$23.37 ¬†¬†¬†‚ÄĒ ¬†¬†¬†2.10%¬† B
ST Cap Gain ¬†¬†¬†$0.07300 ¬†¬†¬†12/19/2014 ¬†¬†¬†12/22/2014 ¬†¬†¬†12/23/2014 ¬†¬†¬†$23.37 ¬†¬†¬†‚ÄĒ ¬†¬†¬†‚ÄĒ
LT Cap Gain ¬†¬†¬†$0.24700 ¬†¬†¬†12/19/2014 ¬†¬†¬†12/22/2014 ¬†¬†¬†12/23/2014 ¬†¬†¬†$23.37 ¬†¬†¬†‚ÄĒ ¬†¬†¬†‚ÄĒ
Dividend ¬†¬†¬†¬† ¬† ¬† ¬† $0.19900 ¬†¬†¬†06/19/2014 ¬†¬†¬†06/20/2014 ¬†¬†¬†06/23/2014 ¬†¬†¬†$22.18 ¬†¬†¬†‚ÄĒ ¬†¬†¬†‚ÄĒ
Dividend ¬†¬†¬†¬† ¬† ¬† ¬† $0.02300 ¬†¬†¬†03/20/2014 ¬†¬†¬†03/21/2014 ¬†¬†¬†03/24/2014 ¬†¬†¬†$21.40 ¬†¬†¬†‚ÄĒ ¬†¬†¬†‚ÄĒ
ST Cap Gain ¬†¬†¬†$0.01200 ¬†¬†¬†03/20/2014 ¬†¬†¬†03/21/2014 ¬†¬†¬†03/24/2014 ¬†¬†¬†$21.40 ¬†¬†¬†‚ÄĒ ¬†¬†¬†‚ÄĒ
LT Cap Gain ¬†¬†¬†$0.01600 ¬†¬†¬†03/20/2014 ¬†¬†¬†03/21/2014 ¬†¬†¬†03/24/2014 ¬†¬†¬†$21.40 ¬†¬†¬†‚ÄĒ ¬†¬†¬†‚ÄĒ
——–
$0.788
tax = $.703*15% (div + long term cap gains portion) + .085*33% (short term cap gains)
= $.10545 + 0.02805
= $.1335

Here is my conclusion:

  • Just based off of the dividends and capital gains distribution over the last year, VDIGX pays a bit more tax, assuming short term cap gains max bracket of 33%.
  • Note that the .31% expense ratio also is a downer for VDIGX.

Based on the taxes paid over the last year, VTMSX wins this round.

I have VDIGX in my taxable account portfolio for the past year…it seems like I invested in a lossy investment, but understanding the context of my investment is probably important as well. Let me tackle that next.

Why do I invest in VDIGX and not VTSMX then?

I split my retirement into two kinds of retirement:

  • Early Retirement funded by Passive Income Streams from my taxable account
  • Real Retirement funded by my tax-advantaged accounts like 401K, IRA, etc.

Details on the funding design for my retirement are in this post.

In my tax advantaged accounts (401K and IRA), almost all the money is invested in Vanguard Target Retirement Funds. Each of the target retirement fund invests in VTSMX. So, I have enough money riding on a total stock market strategy.

For my taxable account, I invest in a different strategies, with two separate buckets/funds for each strategy…to spread the risk a bit more. The strategies I have invested in¬†are:

  • MUNIs…VCAIX…federal+state tax free
  • Balanced fund….VTMFX…capital appreciation + national munis…federal tax free + some state tax free
  • Dividend Investing: current dividends (VHDYX) and Dividend growth (VDIGX)….100% qualified dividends (15% tax) + AMT free
  • Capital growth large and small cap (VTCLX, VTMSX)..does generate some capital gains
  • International (VTMGX)…does generate dividends…almost 100% qualified dividends (15% tax), gets some foreign tax deduction. And hopefully, some capital gains.

So, VDIGX takes the place of a dividend growth fund in my portfolio in my taxable account. The advantages that I considered before investing were:

  • 49 stocks appx…less diversification…but a longer term approach…almost a buy+hold strategy…i.e. limits short term capital gains
  • good fund family…Vanguard/Wellington
  • Considered a solid fund for a down market
  • Appx 10% is foreign market…so, some diversification across geographies (VTSMX has 0% foreign stocks)
  • A little better return¬†than bonds, but a little less risk than capital appreciation/growth stocks.

So, would I change my VDIGX fund investment? Not now for two reasons:

  • It is a portfolio diversification for me in the dividend growth bracket…all companies in VDIGX are not in the index.e.x, 10% is foreign inv unlike VTSMX.
  • It is a less volatile fund…a good fund to keep during market dips…if you consider the last 5+ years of bull market, then a market dip is logical in the next year or two. Lets hope VDIGX earns its expense ratio ūüôā

VDIGX vs VTSMX: Which is better?

VTSMX seems like a good fund to hold for its low expense ratio and the tax efficiency of an index fund. If you do not mind drops in value during a market dip and can hold it through the dip, pick VTSMX.

VDIGX is a more conservative fund, with better performance during a market downturn w.r.t. VTSMX and a comparably less performance in a bull market than VTSMX. If you want something better than a bond fund return with a little bit of additional risk, pick VDIGX.

Hope that shows that both VDIGX and VTSMX can be winners in the right circumstances.