September 1, 2014

Mail Bag: Comparing a Brokerage Account and an IRA for a Long-Term Dividend Portfolio

This is a question about using an IRA to build wealth and comparing it to a regular brokerage account that I promised to answer in the comments section of this post.

Joshua,

Speaking of passing fortunes along to children and grandchildren. I have created a personal goal of constructing a forever portfolio that will pay out dividends to my family for generations to come. 

CommentI have a concern that I would appreciate your thoughts on. You often recommend investors to utilize tax advantaged accounts (like IRAs, roths, etc.) to accumulate their portfolio. However, I understand these types of accounts force position sells through the “required minimum distribution” once you meet a certain age. I’ve also read that there is not a RMD for the first owner of a Roth, but the RMD will kick in for the first generation beneficiary. Additionally, I understand using dividends as your RMD would be taxed at the earnings income level, rather than the current 15 or 20% via a taxable (non-retirement) account. Ideally, my goal would be to never sell and live off of the dividends. I’m thinking that if I didn’t have to sell, the power of compounding and dividend growth after 40+ years would become exponential and far exceed the tax hits I am taking today by not investing my surplus in Roths or IRAs; not to mention my total control over the account and to not be forced to sell of a great asset. So I am leaning towards taking the tax hits now and saving/investing all of my surplus dollars (in excess of my 401k min to receive the match) in taxable accounts to maintain this control and set up the family for generations. I would like your thoughts on this long term strategy. A few givens…my wife and I both work, combined we’re in the 28% tax bracket, ages are 36 and 35, own (cashflow w mortgages) a few of residential rentals.

Would you mind sharing your thoughts?

Thanks

jss027

The good news?  Your question implicitly assumes that the rules for a Traditional IRA are also in force for a Roth IRA, as well as other types of IRAs.  They are not.  There are around 5 or 6 popular IRAs permitted by law in the United States.  The two most famous are the Traditional IRA and the Roth IRA.  Both are not types of investments; they are a type of account.  You can open an IRA at a bank and fill it with certificates of deposit.  You can open an IRA at a brokerage firm and fill it with stocks and bonds.  You can open an IRA at a mutual fund company and fill it with mutual funds.  When your assets become particularly large, you can even use a specialized trustee to “self-direct” the investments in your IRA, using them to do things like buy entire apartment buildings, though the rules are extremely complex, you can only own a certain percentage of certain assets, you can’t be involved in the underlying holding, and you can’t use debt or you might get hit with something known as the Unrelated Business Income Tax.

The difference between a Traditional IRA and a Roth IRA come down to how the taxes are handled and the benefits to which you are entitled.  You can have both a Traditional IRA and a Roth IRA, but between the two of them, you cannot deposit more than the IRA contribution limit in effect for that year.  It was impossible to answer this question without explaining each, so I set aside some time last week and wrote a 4,378 word breakdown of the general specifics of each. 

You will not understand my reasoning unless you have read both of those posts and have an idea of how the Traditional IRA and the Roth IRA stack up to each other in terms of benefits and drawbacks.

With that said, I think there can be no mathematical argument made that a Roth IRA is a vastly superior mechanism compared to a traditional brokerage account when attempting to achieve the objective you describe.  Though you’d need to speak to a qualified professional (I do not now, nor will I ever provide tax or financial advice and every reader is responsible for seeking out their own accountants, attorneys, and tax specialists), the general benefits include being able to withdrawal principal contributions without penalty, there are no mandatory distribution requirements, you don’t have to pay taxes on the dividends, interest, rents, and capital gains you earn during the holding period, there are no age limits on contributions, and you don’t have to pay taxes on the money withdrawn as long as you meet the guidelines (e.g., having the Roth IRA open for longer than 5 years and being 59.5 years old or older).

The problem is the limitation on contributions (currently $5,500 for those 49 or younger and $6,500 for those 50 or older; meaning a married couple might be able to contribute as little as $11,000 or as much as $13,000 per annum, presuming they don’t exceed the income limitations) and the fact super high earners can’t take advantage of the Roth IRA.

When you pass away, your children and grandchildren could inherit the Roth IRA and, true, they would need to liquidate the holdings, but there would not tax consequences for doing so. They could turn around and repurchase, almost immediately, the very assets they had just sold through a regular brokerage account, costing only a handful of commissions.

(There is also another option that can be used in addition to the Roth IRA, but it would only work if you had the scale and means to implement it: Setting up your own Roth 401(k) plan.  It has almost all of the same advantages of the Roth IRA, except mandatory distributions are required at 70.5 years old.  This isn’t concerning since there are no taxes on withdrawals; you could simply turn around and repurchase the very asset you sold to fund the withdrawal.  I only mention it because, under the right circumstances, a married couple could put away $100,000+ per year and never pay any taxes on any of the money, even when they start making distributions later in life.  I’m investigating how to put them in place for my own businesses at the moment; if it can be done, I’m hoping to make the switch in the next few years.)

The downside of this approach is you can’t enjoy the dividends and other passive income yourself during your lifetime unless you want to begin drawing from the Roth IRA.  At your income bracket, though, you should be able to put money aside into other cash generating assets – you mentioned real estate, as well as dividend paying stocks – that are held in regular taxable accounts or forms, unrestricted for your own use in the here and now.

That’s my thought.  A Roth IRA crushes a comparably situated brokerage account under the scenario you described.  It’s not even close.

  • weixiluo

    Joshua, regarding long term investing for retirement accounts, Moshe A. Milevsky writes in the book Are you a Stock or a Bond? that there is a sequence of returns risk when withdrawing money for retirement, i.e. your money will last you longer if you start to withdraw in a bull market and shorter in a bear market. Also, due to the way CAGR (geometric means) work, a lump sum invested in the long term is going to get the same return wether it enters a bear market first, than a bull, or vice-versa. (0.8*1.5 and 1.5*0.8 is the same thing). In other words, the sequence of returns risk only affects you during the withdrawal phase. However, and this is my question, since to my understanding sequence of returns risk is basically DCA in reverse, dosen’t someone who starts dollar cost averaging (or any other kind of regular contributions) in a bear market and then a bull one end up with a higher return than the other way around?

  • Anon

    I think the best thing someone can do is maximize 401(k) contributions ($17,500), upgrade/switch jobs every 2-3 years, and upon quitting convert the 401(k) to a Roth IRA penalty-free (of course, you’d have to pay income tax on the conversion). Rinse and repeat.

    It’s hilarious how many incentives there are to always be switching jobs (promotions, raises, new/fresh faces, broadening your work experience, moving to a new city, more impressive employer names on resume, and on and on).

  • jss027

    Joshua,
    Thanks for the detailed responses. I will certainly ensure my Roth is fully funded every year that I remain eligible. By only sticking with cash generating assets in this portfolio, it would seem one could “effectively” bypass the maximum contribution amounts ($5,500) in time as the growing dividends simulate contributions….($5,500 contributed + reinvested dividends contributed)! Once the dividends grow to $10k – $15k+ that will be a nice little tax free snowball:-)

  • BidAskDividends

    Great article. As is everything with investing, it boils down to personal preference (while still maintaining a logical thesis, of which there are plenty). For retirement, I believe it best to contribute to a 401k up to the company match (investing in low cost index funds if available), and then fully fund a Roth IRA. When you leave your current job, then transfer the 401k into a Traditional IRA. Once your Roth is fully funded, then look to invest in a taxable brokerage (unless you have non tax-deductible debt, you should attack that first). A Roth IRA for a dividend portfolio is perfect, as you can live off the tax-free dividends without having to sell a single share of your portfolio.

  • DividendGrowth

    That was an interesting article. However, do you know if you can do a 401K, SEP IRA and then the ROTH IRA? I already am doing the 401K and SEP IRA, but am not finding out on the IRS website on whether I can also do the ROTH.

    Please advise!

    • DividendGrowth

      I did some research, and found out I can do all three of them.

  • Ray

    Joshua,

    

I have a couple of comments about your excellent advice.



    First, you stated that: “When you pass away, your children and grandchildren could inherit the Roth IRA and, true, they would need to liquidate the holdings, but there would not tax consequences for doing so.”



    Yes, they would have to liquidate the Roth IRA but that liquidation could take place over the person’s lifetime. This could be accomplished by making annual required minimum
    distributions (RMD) from the Roth IRA. If the person inheriting the Roth IRA was fairly young, the RMDs in the early years would be minimal. This has the advantage of allowing the assets remaining in the Roth IRA to continue growing tax-free.



    Second, you state that: “They could turn around and repurchase, almost immediately, the very assets they had just sold through a regular brokerage account, costing only a handful of commissions.”

    

I don’t know about most brokerage firms, but at Fidelity Investments; I believe it is possible to move the actual shares between accounts without selling and repurchasing them. This would results in saving even the “handful of commissions”.



    Of course, you need to consult with your tax advisor to ensure that everything is handled in a legal and proper manner.