Starting today, I’ve asked Nilus Mattive, our resident expert on income investing, to write to you every Tuesday afternoon about new income opportunities. Given the decline in short-term interest rates and the paltry returns on many traditional instruments, the timing of this new addition to your regular Money and Markets e-mails couldn’t be better. Be sure to take full advantage of his well-researched insights, and please join me in giving Nilus a heartfelt welcome to our team of regular authors! — Martin
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Today is my least favorite day of the year.
Like clockwork, Uncle Sam is knocking on my door … he’s asking for a handful of complicated forms … oh, and he wants a large percentage of my hard-earned money, too. Yes, today is tax day.
Nothing galls me more than thinking about just how much of our money gets sucked up by taxes.
First, our employers pay them. Then, we pay them again as individuals. If we manage to save some of the remaining money, we pay taxes on any interest we earn. And even if we spend every dollar … we pay taxes — again — on nearly everything we buy!
Almost equally annoying are all the forms. I mean, isn’t this process supposed to be accessible and understandable to every citizen? Judging by the proliferation of tax software, nothing could be further from the truth.
Still, I insist on doing my own taxes every year … just me, my calculator and a pen. I figure it’s the only way to know how badly I’m getting ripped off. Plus, it motivates me to get better and better at doing everything in my power to lower my taxes going forward. As economist John Maynard Keynes once said, “The avoidance of taxes is the only intellectual pursuit that carries any reward.”
So today I’m going to tell you why my favorite investments — dividend-paying stocks — can not only help you get maximum income but also really help you save some coin on future tax days.
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But before I get to that, I also want to make sure that you …
Take Advantage of All the
Tax Shelters Available to You!
I know, I know. Tax shelters conjure up visions of esoteric legal loopholes and shady offshore accounts. But they’re not just for the wealthiest 1% … in fact, there are plenty of them available to most investors.
Here are just four of them:
#1. 401(k) plans — Most employers offer these retirement accounts, and they’re a great way to keep money away from Uncle Sam. That’s because whatever you contribute is taken out of your pre-tax earnings. Not only does that mean you are deferring taxes on the amount contributed, but you also might be bumping yourself into an overall lower tax bracket.
For 2008, most people can put away as much as $15,500, and if you’re over age 50 you may be eligible to contribute an additional $5,000 in catch-up money!
Meanwhile, your investments grow tax-free until you cash out during retirement. Add in the fact that many companies are willing to match some of your contributions and you can see why I think 401(k) participation is a complete no-brainer.
#2. Individual retirement accounts (IRAs) — Whether you have access to a 401(k) or not, you can also contribute to an individual retirement account every year provided you have earned income that falls within a certain threshold (see my table for the details).
| 2008 IRA Phaseout Levels | ||
| Status | Full Contribution | Partial Contribution |
| Single | Under $101,000 | Under $116,000 |
| Married, Filing Jointly | Under $159,000 | Under $169,000 |
| Married, Filing Separately, Lived Apart Entire Year |
Under $101,000 | Under $116,000 |
| Married, Filing Separately, Lived Together Any Part of Year |
N/A | Under $10,000 |
| *Figures represent Modified Adjusted Gross Income | ||
For 2008, investors can contribute up to $5,000 to their IRA accounts. If you’re at least 50 years old, you can also take advantage of a special catch-up provision and stash away another $1,000.
Just remember that you cannot max out both a regular and a Roth IRA in the same tax year. Your total contributions to all IRA accounts (not counting rollovers and such) must fall within the ranges I just cited.
Which is the better choice — a Roth or a regular IRA? Only you can decide based on your eligibility, age, goals, etc. But I will say that the Roth IRA has a few advantages including no required withdrawals, no age restrictions, and no more taxation of any money earned in the account … EVER!
#3. Coverdell Education Savings Accounts — If you have a child or grandchild you’d like to help out, this type of account is a nice little tax-shelter for them. You can put in $2000 every year for the minor’s education (up until their 18th birthday).
Coverdells operate much like Roth IRAs (they were formerly known as Education IRAs). As long as later withdrawals go to qualified education expenses, your original contributions and any investment returns are not taxed. Currently, those expenses include not only college costs but even private elementary or high school tuition, too. That’s a sweet deal!
The beneficiary of the account has until age 30 to use the funds. After that point, they must either withdraw the money and pay taxes plus a 10% penalty or roll the funds into a new Coverdell account for another beneficiary. But in my book, this is a terrific tax shelter for just about any child in your life.
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| Coverdells and 529 plans keep the tax man at bay and help fund a child’s education. Talk about a win-win! |
#4. 529 Plans — Again, these are great for parents, grandparents, or anyone else looking to help put a child through college. Like Coverdell accounts, they allow contributions to grow tax deferred. Plus, distributions will be tax free as long as they go to qualified education costs (in this case, it’s only post-secondary education purposes).
In addition, depending on the plan, the future student is not the only one who reaps tax benefits … the contributor can too! See, 529 plans are sponsored by individual states and some will allow residents to write-off the money they put into a plan against their income taxes. Considering that some 529s accept as much as $300,000 in contributions over the life of the account, your tax benefits can be extremely significant!
Okay, so now that I’ve told you about some “everyman” tax shelters, you’re still left with the giant challenge of figuring out what to invest in. What’s more, you still have to find ways to maximize your profits and minimize your taxes in your regular investment accounts.
Well, my solution for both purposes is the same …
Dividends: A Tax-Friendly, Wealth-Building
Powerhouse for Your Investment Portfolio
Look, dividends represent non-refundable investment returns … they usually indicate that a company has strong underlying fundamentals … they prove that management cares about rewarding shareholders on a regular basis … and they can multiply your wealth if you regularly reinvest them.
Even better, the yields on some of my favorite dividend-paying shares are currently at multi-year highs while the yields on some other popular income investments — Certificates of Deposit (CDs), money markets, and certain bonds — are at multi-year lows.
For all these reasons, I heartily recommend stuffing dividend-paying stocks into your long-term investment accounts, especially retirement plans like 401(k)s and IRAs.
But since today is tax day, I want to focus on another lesser-known aspect of dividends, and a great reason to add them to your taxable investment accounts …
Since 2003, most dividends are taxed at a much lower rate than other investment earnings!
Reason: The Jobs and Growth Tax Relief Reconciliation Act of 2003 lowered the tax rate on most stock dividend payments. For most people, the tax rate on qualified dividends is now just 15%. Investors in a lower income bracket actually pay no tax on their dividend income. And an extension, signed in May 2006, guarantees these lower rates through 2010!
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| Uncle Sam wants a big piece of your income. But most dividends are now taxed at a lower rate, letting you keep more of your own money. |
The advantage of this tax break to a taxable income portfolio can be considerable. Say you have $100,000 invested in dividend-paying stocks with an average yield of 4%. That’s $4,000 in dividend income every year.
If those payouts were taxed at your ordinary income rate, you could end up giving back as much as $1,400 in taxes (based on the highest bracket of 35%).
In contrast, under the lower rate, you would owe only $600. That’s an additional $800 in your pocket!
I can only hope that this lower rate becomes a permanent change. Remember, dividends represent your share of a company’s profits. There’s no reason the corporation should pay taxes and then watch its shareholders pay more taxes on the very same profits.
For now, suffice it to say that dividends are a great way to stick it to the tax man. The lower tax rate on dividends is a great reason to keep income stocks in your regular brokerage account … and for many investors it’s just one more reason to favor dividend stocks over other income investments like CDs given the current interest rate environment.
Sincerely,
Nilus
P.S. If you want to learn more about my favorite dividend-paying stocks, subscribe to my monthly newsletter Dividend Superstars. Not only is the cost just $39 a year, but I’ll also send you a whole series of special reports to get you started immediately. Click here for all the details.
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Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Tony Sagami, Nilus Mattive, Sean Brodrick, Larry Edelson, Michael Larson and Jack Crooks. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include Kristen Adams, Andrea Baumwald, John Burke, Amber Dakar, Dinesh Kalera, Mathias Korzan, Red Morgan, Maryellen Murphy, Jennifer Newman-Amos, Adam Shafer, Julie Trudeau and Leslie Underwood.
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