Advanced Tax – Retirement Income Planning

Dividend Strategies at Retirement — Taxable Accounts versus IRAs?

At retirement, taxpayers with sufficient portfolio-based assets will need to consider the most tax-efficient method for holding dividend-paying stocks since qualified dividend income, unlike interest income, is now eligible for a reduced-rate tax structure for federal income tax purposes (i.e., 15% or 5%). In addition to this tax-favored treatment, dividend-paying stocks have historically been a good hedge against inflation since dividend payouts have tended to rise approximately 1% per annum faster than the rate of inflation.  Retirees often hold dividend-paying securities in several different types of accounts — taxable accounts, traditional IRAs, and Roth IRAs, for example.  This assignment involves making recommendations as to how best to structure dividend-paying stock investments for a retiree under the following assumptions.

       (1)   Stocks in retirement accounts are limited to traditional and Roth IRAs.  Funds in any employer-sponsored retirement plan, like a 401(k) that are earmarked for dividend-paying stocks have already been transferred to a self-managed IRA. 

       (2)   All dividend income is generated from direct ownership of stocks rather than ownership of mutual funds.

       (3)   The retiree is at least 59.5 years of age, so that any withdrawal from an IRA is not subject to the 10% penalty tax under IRC Section 72(t).

Requirement #1  — Qualified Dividends and Mandatory Distributions

Briefly summarize (with Code citations, as appropriate) the present requirements concerning when dividend income qualifies for the reduced-rate (15%/5%) structure.  Also, summarize (with Code citations, as appropriate), the present requirements concerning whether minimum annual distributions are required for traditional and Roth IRAs and, if required, when they can and must occur.

Requirement #2 — Dividend allocation when all income required for living expenses

If all dividend income is required for living expenses, a retiree must determine how best to hold dividend-paying securities in his or her various accounts, particularly in the event that different stocks have different dividend yields.  The dividend yield for “blue chip” stocks currently averages around 2%, although the yield varies considerably across companies.  Consider the following scenario:

Taxpayer A is ready to retire and wishes to derive a portion of his retirement income from dividend-paying stocks.  He has $300,000 to invest in stocks.  He intends to use all of the dividend income generated from the stocks for living expenses.  Taxpayer A has at his disposal a taxable account, a traditional IRA, and a Roth IRA in which to place the stocks.  He allocates $100,000 to each of the three types of accounts and has the following investment returns:

              One $100,000 amount earns an average yield of 1%.

              Another $100,000 earns an average yield of 2%.

              The last $100,000 has a yield of 3%.

Thus, on average, the overall stock portfolio yields 2%.  Taxpayer A has an ordinary tax rate of 25%.  All dividend income qualifies for the lower rate of 15% if taxed currently. 

Required: Prepare a schedule enumerating the gross proceeds, tax liability, and after-tax proceeds for the current year’s dividend income with the dividend-paying investments ($100,000 per account) allocated among the three account types in the most tax-efficient manner.  Explain why your allocation approach yields the highest after-tax amount.  [Hint: It may prove helpful to determine the after-tax proceeds under various allocation scenarios to prove that your choice is indeed the most tax-efficient.]

Requirement #3  — Dividend income exceeds living expense needs  

At retirement, if all dividend income earned during the year is not required for living expenses, a

retiree needs to determine whether the dividend income should first be withdrawn from his or her taxable account, traditional IRA, or Roth IRA.  Consider the following scenario.

Taxpayer B requires a $1,700 after-tax distribution from dividend income for the year.  She presently has dividend-paying stocks in both a taxable account and a Roth IRA.  All withdrawals from the Roth IRA are tax-free.  The dividend income in the taxable account is taxed at a 15% tax rate.  The stocks in the taxable account generate $2,000 of dividend income annual on a pretax basis, and the stocks in the Roth IRA generate $3,000 of dividend income.  Assume that the dividend income compounds at a 6% annual return before consideration of any tax liability, and for the sake of simplicity, that all dividends are earned at the beginning of each year. 

Required: Prepare two schedules detailing the accumulated after-tax balance at the end of five years in each account (taxable and Roth IRA) stemming from dividend income assuming (i) dividend income is first withdrawn from the taxpayer’s taxable account and (ii) dividend income is withdrawn first from the taxpayer’s Roth IRA instead of her taxable account.  Assume that zero dividend income has been earned in each account until the beginning of year 1.  Explain which approach is better (i.e., withdraw first from taxable account or first from Roth IRA) and why the selected approach is superior in terms of tax efficiency. [Hint: It may prove useful to prepare a schedule showing the before-tax earnings, after-tax earnings, and end-of-year balance for each account for each year.]

Requirement #4  — Dividend income needed exceeds amount generated in taxable account but not amounts generated by traditional and Roth IRAs combined.

If a retiree has withdrawn all available dividend income from his or her taxable accounts, and remains in need of income, discuss the implications to the retiree (on an after-tax basis) of withdrawing the additional income from a traditional IRA versus a Roth IRA.   Assume that the traditional IRA had been funded exclusively with pre-tax contributions.  Also, note that income withdrawals from a traditional IRA are taxed as ordinary income.  How is your analysis affected by assuming (i) tax rates are constant over time or (ii) tax rates are not constant over time?  [Hint: You may wish to derive numeric examples to help support your assessment, although such computations are not required.]

Requirement #5  — Dividend income is not qualified

  

How would your answers to requirements 2, 3, and 4, change, generally, if the dividend income being generated is non-qualified as opposed to qualified?  Explain.  You may support your explanation with numeric computations, although such computations are not required.