Cash flow is King! Net worth is awesome, don’t get me wrong, but if it’s not providing an income, it doesn’t really help you reach financial independence. I’m on a mission to get $100,000 flowing into my life from sources other than my employer. When and how I turn on this cash flow can have a big impact on how long it takes me to reach financial independence.

Cash flow comes with a price while one is still working and producing an income. The higher the income, the higher the price. I will likely be in the 33% marginal tax bracket for 2017, so for every additional dollar that I make of regular income, the most I will get is $0.66. My income will be over $75,900 (married filing jointly) and very likely below $470,700, so any qualified dividends that I receive will be taxed at 15%, so I’ll get $0.85 for every dollar earned in that realm.

For this post, I am going to refer to cash flow in two distinct categories, active and passive. Active cash flow is anything that is produced from activities that I am undertaking, like working at my job, writing this blog, or any type of side hustle. Passive cash flow is income that is produced by my assets, like stock dividends, ereit dividends, rental income, etc.

While I’m still working a full time job, my goals are to increase my active cash flow as much as possible, while decreasing my passive cash flow to as close to $0 as possible. This does not mean that I don’t want my assets to grow, it means that I want them to grow without the IRS considering the growth as a taxable event.

While 33% is a big number to pay on active income dollars, it is what it is and I’ll pay that 33% all day long if it means I’m adding more dollars to my net worth. I’d much rather put $0.67 to work for me in investments than $0, which is what I’ll have if I don’t earn that dollar in the first place. Additional active income is always welcome at my house.

So if I’m willing to pay the 33%, it would seem logical that I’m also willing to pay the 15% on passive income, like dividends. Wrong!

I am much more concerned about paying taxes on my passive cash flow.

I’m greedy, I want every single dollar that I’ve invested to stay put, compounding returns over time. If I realize investment gains, it’s a taxable event, and I’m required to give some of those dollars to Uncle Sam, which means that they are done working for me forever. Why pay taxes on gains until I need them to live off of? I’m trying to get as much of my passive growth as possible into vehicles that will shield the gains from being realized until I need to use the money to live off of.

For example, let’s look at two different stock investment scenarios. If I buy high yield dividend stocks in my non-retirement (taxable) accounts, I automatically lose at least 15% of those dividends when tax time rolls around. So, say I put $100,000 into AT&T, which currently pays a 5% dividend which equates to $5,000 a year on the $100,000. After paying the 15% tax of $750, I only get to keep, or reinvest, $4,250 of that $5,000. This essentially turns into a fee of .75% per year, which is no bueno. We all know how bad a fee like that will inhibit progress over time.

Let’s say that on the same day as I bought the AT&T stock, I also put that $100,000 into a stock that paid no dividends. I will realize no taxable gains until I sell that stock, meaning that if this stock and AT&T had an identical 8% rate of return over the next 5 years, I’m better off in the stock that does not incur the .75% “fee” that comes with the dividend payout.

Here’s a breakdown of the numbers over 5 years:
Initial investment of $100,00
AT&T Stock: 5% qualified dividend

Taxes*: $5,427.95

Ending balance: $141,504.86
Stock that pays no dividend

Taxes: $0

Ending balance: $146,932.81
Difference 3.69%
It gets worse over time, here is the breakdown over 10 years
Initial investment: $100,000
AT&T Stock: 5% qualified dividend

Taxes* : $15,656.25

Ending balance: $200,236.25
No dividend

Taxes: $0

Ending balance: $215,892.50
Difference: 7.25%
It gets way worse over a longer time, here is the breakdown over 20 years
Initial investment: $100,000
AT&T Stock: 5% qualified dividend

Taxes* : $65,150.15

Ending balance: $400,945.57
No dividend

Taxes: $0

Ending balance: $466,095.71
Difference: 13.98%
* I’m including the opportunity cost in this as well as taxes, all scenarios assume a 15% capital gains tax rate.

Wow, that’s a pretty big hit!

Obviously, this scenario is controlled so that the performance of each stock was identical. The odds of that happening are slim, and unless you are an experienced investor, I highly encourage you to buy low cost ETFs or market index funds, not individual stocks. The same principles will apply to a high yielding fund vs a low yielding fund.

Another key point is that this scenario is only relevant for any taxable accounts. Dividends that you receive in tax shielded retirement accounts, like Roth or standard IRAs, and 401Ks will not be taxable until much further down the road, if at all.

As I get closer to retiring from my full time job and entering a much lower tax bracket, I will start to turn on the passive cash flow faucets. Until then I’m going to avoid high yielding dividend stocks in my taxable accounts.

Shaka!

Bossman