On Monday Jason wrote a great overview about dividend investing . Since you now know what dividends are all about, I figured it would be a good opportunity to do a guest post on the subject. I write about the stock market and personal finance at my blog Stock investing 101.

Photo by gfpeck

Dividend investing is the best way to generate passive income and become wealthy, period. It is the perfect example of making your money work for you.

AT&T pays out a 6.7% dividend yield. This means for every 100 dollars of the stock you own you will be given $6.70 a year from the company as a bonus for just being a shareholder of the company. Compare 6.7% to the interest you could get from a standard checking account or a CD. You are getting at least 3 times the return from owning AT&T versus investing in a CD, and that is not factoring in any potential increase in AT&T’s share price.

Most dividend paying companies also offer a DRIP program, DRIP stands for Dividend reinvestment program. If you opt for the DRIP program the money you receive each quarter from owning stock will be used to buy more of the stock instead of being given to you in cash. This is a great way to take advantage of compound interest.

Jason mentioned he purchased 80 shares of AT&T. If he opted for the dividend reinvestment plan those 80 shares would grow to 85.4 shares after just one year. After 5 years his purchase of 80 shares of the company would now have ballooned to almost 110 shares of the company. After those 5 years, assuming AT&T kept its dividend rate steady [which is very conservative when you consider that AT&T has a long track record of consistently raising its dividend] Jason would then be actually getting a 9.3% yield on his original investment. 110 X 1.68= 184.8/ [25.25[share price]X 80= 2020].

The numbers only get more and more impressive and mind boggling over time. In ten years AT&T could go from paying his Netflix membership to making his car payments, in thirty years AT&T could pay his mortgage.

The best thing about this is that there is almost no work involved. After you make your initial investment everything is on autopilot.

Here is a short overview of 5 different dividend paying companies in 3 different sectors to get you started. Remember that this list is not comprehensive in the least bit and it is far from fool proof:

• AT&T: Jason and I have mentioned this company countless times for a reason. It pays out a whopping 6.7% yield, it is in a stable sector that all of us understand, and I don’t see people getting rid of their cell phones or their Internet connection anytime soon.

• Coke: Coke is another great dividend paying company. Its yield of 3.2% is not as impressive as AT&T’s but it is still a great value. Coke raises its dividend religiously so I expect even more from it in the future.

• Pfizer: Pfizer is a huge health care conglomerate. It pays out a very impressive 4.1% dividend yield at the moment and it is a very solid company. It presents a great value to investors.

You will not get 30% yearly returns from investing in dividend paying companies but you will get the best possible return in the long run along with the most stable investment with the least amount of work involved.

If you are interested in learning more about dividend investing, I highly recommend the book The Ultimate Dividend Playbook from Morningstar (written by Josh Peters).

Note from Frugal Dad: After giving it some thought, and investigating the plan with my online brokerage, I have decided to sign up for their dividend reinvestment program. Dividends will be reinvested in eligible securities held in our portfolio, allowing us to build our positions more quickly without an added fee.

This question is especially important if you are considering retiring soon or if you have been offered an early retirement package.

If you’re like me, when you try to imagine what lies ahead, you think about your most recent experiences and extrapolate going forward.

Investors do this more than anyone – at least as far as I’ve seen. While I can see why folks do this, it’s really not a very good exercise and I’ll show you why.

If you think back over the last 10 years, you’ll agree that it hasn’t been a picnic for investors. Depending on when you calculate the 10-year average, you could get a slightly negative return or a slightly positive return for that period. But either way, it’s a lousy return.

Based on that, investors might forecast a crumby 10-year return going forward.

Even though we’ve heard that old expression that the past is no guarantee of the future when it comes to investing, what else do we have to base our decisions on other than the past?

Well…I do want you to consider the past when you think about the future.  Just think about it a little differently.

Let’s look at an example to help explain this idea.

If you review the chart below, you can see that the 10-year trailing return in 1974 was an ugly -3.8%. That means had you invested in 1965 and held on to your investments through the end of 1974, your annualized return was -3.8%.

S&P 500 Trailing 10-Year Annualized Return

Real Returns Over the Next:

But what happened over the next 10-year period? The market had an annualized 6.9% return. In fact, after each of the last 5 decade-long market meltdowns, the market did pretty well.

Is that a guarantee that the next 10 years will be years of wine and roses for all?  Not by a long-shot. But it does indicate that history is on our side. It shows the importance of not falling into the trap of thinking our most recent experience is going to be repeated in the future.

Exactly one year ago, did you predict that the market would do so well by the end of the year?  I sure didn’t.

While we face real challenges ahead as a nation and as investors, it would fly in the face of all the facts to become pessimistic right now.

What do you think we’re in store for over the next 10 years?

The past year and a half has been rough for investors, although many investors have grown tired for the financial advisers and have become DIY investors, others who have lost money are too frightened to do it themselves and have turned to financial advisors.  Although nothing is wrong with having a good financial adviser, you have to understand that there is no magic to investing, the financial advisor doesn’t do anything you would be able to do yourself so why pay those hefty fees? A little while ago I provided some investing tips for successful investing, if you follow most of those tips you should be fine.

How to Become a Successful Investor?

There is no magic to investing, although the investment industry tries to confuse investors and make things look complicated, there is no reason to be worried.  First step to becoming a successful investor is to keep things simple! I am a big fan of simplifying finances and investing, there are too many investment options available and too many contradictory opinions, the best thing you can do is keep your investment portfolio simple, here is how.

How to Simplify Your Investment Portfolio?

1.  First find a good online discount broker, you can follow these tips to find the best discount broker for you. Discount brokers can save you a lot of transactions costs when it comes to investing.

2.  Establish your asset allocation and investment policy statement. Asset allocation will help you determine how to allocated your assets between different asset classes. When you have your written investment policy statement ensure that you stick to it, only this way can you keep your emotions out of your investment and simplify your investing. You can download a sample investment policy statement from our site.

3.  Purchase Index funds or ETFs, often investors purchase expensive mutual funds thinking active manager will perform better. The fact is that active managers lose to index funds, there is no point in paying hefty fees to mutual fund mangers when you can get better performs by investing in index funds and ETFs.

4. Ignore the Noise. Don’t pay attention to the media and so called experts, the media is known to exaggerate the reality and the so-called experts will only confuse you since most of them don’t agree with each other. Keep your focus on your long-term goal and ignore the noise.

5. Rebalance. Although I like passive investing, passive investing does not mean just leave things. Markets will fluctuate and your portfolio asset allocation will change you need to rebalance your portfolio along with market changes, this will ensure you are staying within your determined asset allocation.

Just following those five steps you will be able to dramatically simplify your investment portfolio, as I mentioned at the beginning there is no magic to investing, just keep things simple and follow some investing rules of thumb.

How do you feel about your investment portfolio? Do you find it confusing? Have you simplified your investment portfolio? Any tips you’d like to share?

A few months ago I decided to give social lending at Lending Club a try (my Lending Club review). I was intrigued by Lending Club’s business model, and having a little experience on the other side of the loan officer’s table, I thought maybe I could score a decent return.  Here are a few updates from my Lending Club progress report.

For my initial social lending experiment I decided to invest a small amount of money in two loans. Lending Club categorizes borrower profiles based on a variety factors such as credit score, income (which they verify).  I balance this against the borrower’s personal story.  Trying to read credibility in black and white is not always easy, but when you read someone’s story in the context of their other information you can usually get a feel for their authenticity.

To spread my risk out a bit, I balanced investments in Lending Club borrowers between a medium-risk borrower with a low-risk borrower. Both loans are being paid and are in good standing, yielding an approximate net annualized return on investment of roughly 11%.  Not bad for a rookie.

Click for a larger view

Advantages of Investing With Lending Club

• You have the opportunity to earn better returns than traditional market investing
• Lending Club is selective about the types of borrowers they allow to join
• Flexibility to trade notes, or hold them and reinvest (or withdraw) the interest
• Free to join

If you are interested in investing with Lending Club I suggest starting with a small percentage of your overall portfolio until you get your feet wet.  I think you’ll find their platform very straightforward, whether you decided to invest in individual loans, or a collection of loans.  Of course, I haven’t invested enough to exactly live off passive income at this point, but it’s a start, and the potential is there for investing more down the line.

If you are over 70 ½ you might consider converting your Traditional IRA to a ROTH IRA right now. If so, you’ve got plenty of good reasons to think about it.

First, the market has done a number on your IRA account value. Since you must pay ordinary income tax on any amount you convert, low values mean lower taxes.  A good thing.

As an added bonus, Congress passed a law in December of 2008 lifting the requirement to take distributions from your IRA (for 2009 only). So if you don’t take your RMD (required minimum distribution) you will have lower taxable income.  That means it’s easier to qualify for the conversion (your AGI must be less than $100,000 to convert). It also means the tax on the conversion might be lower.

So the stars are all aligned…but does that mean you should convert your Traditional IRA to a ROTH?

The answer to this question really depends on your unique situation.  It also depends on your ultimate goal. If your main goal is to accumulate wealth, this might indeed be the time to convert. I ran some numbers and concluded that (for the right person) it makes sense to convert.

Here is what I assumed:

1. You have $100,000 in an IRA and $35,000 in cash.

2. You are in the 35% tax bracket.

3. If you convert, you will use the cash to pay the tax due.

4. You can earn 5% on your money in the IRA.

5. You also earn 5% on the cash but since it’s in a taxable account, your net earnings are reduced to 3.25%. (I know you can’t earn 5% on cash right now.  I’m using 5% so we can compare apples to apples and also because this illustration is for 20 years plus. You never know where interests rates are going to be a year from now….do you?)

6. You are currently 70 ½ and you if you decide to keep the Traditional IRA as is, you will take out just the RMD amount and deposit that into your savings account.

Let’s consider the Roth Conversion first. It’s simple.  We use the $35,000 to pay the 35% tax on the conversion so it’s gone.  The Roth continues to grow at 5%.  At the end of 20 years, the value of this account is a cool $265k.  NICE.

Now consider the alternative.  Let’s say we don’t convert our Traditional IRA.  Look at the chart below.

Column B shows “IRA VALUE” growing at 5%. It’s reduced by the amount you withdraw to satisfy the RMD (column D).

Column C shows the RMD factor.  This is simply the number the government makes you use to determine the amount of your RMD.  For example, in year 1, the factor is 27.4.  You divide the balance – in this case $105,000 by 27.4 and arrive at an RMD of $3832.  This is the amount you must take out in the first year – unless it’s 2009 of course.

The cash is shown in column E.  You deposit your RMD (net of tax) into that account and this, plus the prior total grows by 3.25%.

After 20 years, the total is $266,191.  So you should definitely NOT convert….right?

Not so fast……

Remember that you’ve paid the tax on the ROTH conversion and you haven’t on the Traditional IRA. If you were to take all the money out of the Traditional IRA, you have to pay that tax.

Again, if you want to approach this question from the standpoint of capital accumulation, you have to look at how much money you’d have if you took all the money out of the Traditional IRA and paid your tax.

Now, truth be told, you don’t really know when you’ll pay that tax.  You could die & your grandchildren could inherit your traditional IRA and they could defer most of the tax for a very long time.

The only way to decide what to do is by making certain assumptions.

As you can see from the graph below, if you don’t need the money and don’t think you’ll ever need the money, the Roth is a good choice.  Again, this is only if you approach the question from a wealth accumulation point of view.  If you are looking at income, it’s a whole other ball game.

You can see, even if you don’t consider the latent tax liability, you’ll have more wealth in year 23 if you convert to the ROTH.

Bottom line?  This calculation assumes that you have money outside of your Traditional IRA and can use that to pay the tax on your conversion. If you find yourself in that situation and your main objective is to grow your wealth – rather than create retirement income – the conversion could be for you.

But I think there is a more important take-away. Never listen to anyone who makes a blanket statement about converting your IRA or not.  There are too many variables and assumptions. The right answer depends on what you want to do with your money.  It’s just stupid to think that one solution fits everyone. For example, if you told me that your main goal was to maximize retirement income, my answer might be completely different.

Have you converted your IRA into a Roth?  Are you considering doing so? Have I missed something that you think is critical in making the decision?

This was a guest post by Neal Frankle, CFP. Neal is an author and avid blogger. Subscribe to his blog at www.wealthpilgrim.com.