Early retirees should still use a Roth IRA

Dividend Mantra (DM) is an investing blog that I read regularly. It’s a terrific resource and should definitely be added to your blog reader. Back in August 2013, DM wrote an post entitled, “Why I Hold 100% Of My Equity Investments In A Taxable Account,” that discusses the idea of dividends as tax-efficient investments. (Most of his posts get a ton of comments and this one was no exception, especially considering the relatively controversial nature of this post.)

While I do agree that qualified dividends are tax-efficient, I still do think that investing in a Roth would be smart for him. His main arguments for investing only in taxable accounts include the need to access the dividend income early in life and the fact that taking income from IRAs before normal withdrawal age is difficult.

As Dividend Mantra is on-track to retire by age 40, he definitely would have to hold out from touching his IRA dividend income until the usual retirement age, right? Not necessarily.

In the paragraphs below I will discuss my strategy for Roth IRA Dividend Harvesting.

Had DM invested in a Roth IRA he’d be able to withdraw at any time and without penalty up to the total amount he contributed, leaving any capital gains and earnings until retirement age. And, to make things even better, he could withdraw that money as dividends, keeping the dividend paying investments intact and, therefore, not letting the stream of dividends diminish. Future capital gains and any dividends that he should choose to leave would then compound tax-free.

(As mentioned at the beginning of my post, a Roth IRA does not allow for immediate tax deductions. However, DM is investing post-tax money in his taxable accounts anyway, so that benefit of the traditional IRA does not apply here.)

Let’s do some calculations to see how my theory would work out:

Assumptions:

  1. 5% capital appreciation per year
  2. 3% dividend paid at year’s end
  3. Dividend growth is not taken into account

The chart that I’ve created below shows what would happen in the theoretical scenario where DM contributes $5,500 a year into a Roth IRA beginning at age 28 and ending at his retirement age of 40. The total contributions would be $71,500. Assuming a 5% capital appreciation combined with a static 3% dividend yield, the final value of his Roth IRA at age 40 would be $127,682. This would generate $4,021 at age 41, or year 1 of retirement. Per Roth IRA rules, he’d be able to withdraw penalty and tax free the initial $71,500 that he contributed.

Screen Shot 2014-06-20 at 2.24.53 AM

By withdrawing that 3% in dividends a year he’d remove the total contribution of $71,500 by age 53 (year 13 of retirement). On year 1 he’d withdraw $4,022 and by year 13 he’d be withdrawing $7,223. Given the increasing withdrawals, he wouldn’t quite make it to the “retirement” age of 59 1/2, which is the point he could begin withdrawing dividends and/or capital gains tax free. (However, he could prolong this by reducing the annual withdrawals to a fixed amount, like $4,000.) Since DM wants to live off the dividends anyway and not touch the underlying capital, I feel this scenario is fair and realistic.

This is why I don’t buy the argument against investing in a Roth even “if [he’s] going to be accessing [his] dividend income extremely early in life.” Investing in a Roth does not preclude one from still living on the dividends. DM has been saving and investing significantly more than $5,500 a year. By that respect his taxable account should still provide the majority of the dividend income with the non-taxable Roth IRA portions being relatively small in the grand scheme of things.

The tax consequences of removing the dividends from the Roth would be an additional benefit: the Roth provided dividends would not count as qualified dividends. As DM mentioned in his post, the 10% and 15% tax brackets pay a 0% tax rate on qualified dividends. Therefore, theoretically, DM could make up to the maximum amount to stay within the 15% tax bracket ($36,250), take an additional $4,000 a year from his Roth dividends, and still pay 0% in income taxes. This benefit would be even more substantial once the Roth portion of his portfolio has a chance to compound even further.

Since DM had only been withdrawing dividends for those 13 years of retirement (given a fixed 3% withdrawal rate at the level of his dividend yield), his stocks had still been gaining 5% a year in my scenario above. Because he had not been touching the underlying capital, the Roth IRA portfolio would be worth $240,764 at year 13.

Then for an approximately 7 year period (ages 54-60), DM would have to rely on the dividend income from his taxable accounts. By retirement year 20 (age 60), there would be an additional 7 years of 5% appreciation compounded with 3% dividend yield resulting in a final portfolio value of $412,626, able to generate $12,379 a year in tax-free dividends. Upon age 59 1/2 he’d be able to then access the entire Roth IRA portfolio however he would want.

The earnings from a Roth IRA can also be used to pay for qualified educational expenses, pay for unreimbursed medical expenses, or health insurance if unemployed. Also, the earnings can be withdrawn via distributions made in substantially equal periodic payments, though this can get complex as DM mentioned. There are other methods to access the money prior to reaching 59 1/2, if it is truly needed. (See Roth IRA Withdrawal Rules)

Retire Before Dad discusses his use of the Roth IRA here: Utilize the Roth IRA as an Early Retirement Tool


Important Note: I think the method discussed above of harvesting the dividends to remove the initial contribution is valid. I’m still awaiting clarification on this. I know that contributions can be removed at any time without penalty (since the taxes have already been paid). What is a little less clear is that if the original money is somehow earmarked and that is only what can be removed penalty free. As long as the dividends and earnings that exceed the original contribution are left in the Roth IRA, I think it should be alright. I’ll update this post as I learn more.

Point one: This article from Pioneer Investments states:

Assume you contribute $5,500 to a Roth IRA. In this case, a dividend of $150 is paid to your account; however, its overall value declines by $200, which leaves $5,450 in the account. You can withdraw that entire $5,450 tax-free at any time, since you are not taking out more than your original investment.

By this logic, it would appear that the money can be removed by any means just as long are “you are not taking out more than your original investment.”

Point two: Even if my method of dividend harvesting doesn’t work, you could still sell off an amount of stock equal to the dividend amount, thereby removing the original contribution and yet allowing the dividends to accumulate.

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