Over the last few months, I’ve changed my investment strategy for the little bit of after-tax money I have available to invest outside of retirement plans. It’s worth noting before going any further that it almost always makes more sense to put available money in tax-deferred or tax-free retirement savings vehicles, such as the Roth IRA, before investing outside of these plans.

I take sort of a dual approach, recognizing that I may in fact need access to some of my savings and investments before I reach 59 1/2. Roth IRA contributions are available to withdraw any time since they represent investment dollars that have already been taxed. However, I’d like to let the Roth IRA grow as long as possible without removing contributions.

Investing Money in Taxable Accounts: The Options

When it comes to investing money in taxable accounts, the options are endless. Here’s a short list:

• Mutual funds
• Individual stocks
• Bonds/Treasuries
• CDs
• Money Markets
• Cash
• Metals

Each of these vehicles offer different degrees of risk and potential investment reward. Obviously, in a low-rate environment like the one we are in today, cash-based investments don’t offer much in the way of return. Most money markets are hovering around 1.5% APY, and regular savings accounts and short-term CDs are even worse.

I’m generally a fan of mutual funds, and have most of my retirement in Vanguard funds. However, after dabbling in mutual fund investing for our taxable accounts, I’ve found they don’t offer the element of control I like to have over that money (deciding when things are sold to take the tax hit, etc.).

Individual stocks can also be promising, but on the risk scale these are near the top. I’m won some and I’ve lost some, and in all honesty, I’ve done well just to break even on most of my trades over the last few months. Any small gains I earned were eaten up by broker fees, the rest in capital gains taxes. Seemed like a lot of work for a relatively small reward (in most cases).

Dividend Reinvestment Plans

I still like the idea of investing in particular companies that I believe will do well over the long term. Companies that have been around for a few decades, cranking out profits and returning some of them to shareholders.

These large, blue-chip growth companies can typically withstand a market meltdown, and often experience modest gains in bull markets as well. But their real beauty lies in their dividend. It is that dividend that spins off consistent income to investors quarter after quarter that makes them so attractive.

Many of these companies offer a direct purchase dividend reinvestment plan, meaning you can buy stocks directly from a plan administrator, often for much lower commissions than you would find at brokerage.

After an initial purchase you can set up an automatic withdrawal from your checking or savings account to purchase shares (even fractional shares) of the company. Dividends earned may be reinvested to purchase more shares, providing a compounding effect that can quickly grow the number of shares owned.

Many years down the road, once we’ve accumulated a large number of shares in a particular company, we may opt to start receiving dividend payouts in cash. Most transfer agents allow a direct deposit to your checking account.

A Working Example

Imagine you are 55 years old, and 30 years ago you dropped a couple thousand dollars into a stock like Procter and Gamble (PG). That single investment would be worth more than $123,247 today. You would have started with 27 shares, but by reinvesting dividends, you now would have over 1,980 shares. *I found that example on the Fool.com website, a great source for dividend investing info.

Proctor and Gamble currently pays shareholders an annual dividend of $1.93 per share, or roughly $0.48 per share each quarter. That means every three months you would be receiving a check for $950. Doesn’t sound like much?

What if you had invested a couple thousand back in 1980, and then decided to add $100 a month to your holdings all along. The math is a little tricky, so we’ll just use some very rough estimates. Let’s assume that continuing monthly investment allowed you to add another 3,000 shares, so you now own 5,000 shares of Procter and Gamble. Each quarter, you would receive a dividend payment of $2,412.

Now imagine you took the same dividend investing approach with a couple other favorite holdings…maybe something like Coca Cola and Exxon Mobile. You can see how a sustained investment in a handful of high-yield dividend stocks could spin off a comfortable income down the line.

What are the Risks?

I certainly don’t mean to present this as a zero-risk investment, because there are risks. One of these companies could go bankrupt and you could lose your investment. The company could cancel its dividend, as many bank stocks did during the recent recession, or BP did after the Gulf oil spill.

If one of these stocks abruptly cancels its dividend, and you are counting on it for income, you may be forced to sell all of your shares and move them to another investment, which could result in a realized loss or a sizable tax event.

There is also a political risk in the form of higher taxes. Qualified dividends are currently taxed at the long-term capital gains rate, but there is a move to count these earnings as ordinary income, which could significantly increase the tax liability – hitting those relying on dividend income the hardest.

For these reasons, it makes sense to make this only a part of your overall investment strategy. I would still invest in well-diversified mutual funds, bonds or bond funds and consider owning some assets outside of the market (real estate, farmland, silver, etc.).

How to Pick a Dividend Stock

In terms of stock picking, I recommend checking out listings such as the Dividend Aristocrats, a collection of S&P 500 companies that meet strict criteria to be included on this list, such as:

• Companies must be a member of the S&P 500.
• Companies must have increased dividends every year for at least 25 consecutive years.
• Companies must have a float adjusted market capitalization of at least US $3 billion as of the rebalancing reference date.
• Companies must have an average trading volume of at least US$ 5 million for the six-months prior to the rebalancing reference date.

Source: S&P 500 Dividend Aristocrats factsheet

You may have additional screening criteria to add, but this is a good starting point. The members of this list represent large, stable blue-chip companies, often with world-wide operations and a solid history of producing profits. Many of them are somewhat recession-resistant (think of Proctor and Gamble’s product line – people still buy detergent and cleaners and batteries and paper products in a recession).

Where to Get Started

Most company websites have an “Investor Relations” area with information on shareholder services such a dividend reinvestment programs, direct purchase plans, etc. Most DRIPs are handled through an administrator, such as BNY Mellon Shareowner Services or ComputerShare.com.

If the company you are interested in investing does not offer a DRIP or direct investment plan, there are other cheap ways to buy dividend stocks. You can always use a discount broker such as TradeKing, Scottrade or Sharebuilder. Sharebuilder even allows fractional share investing so you can purchase a specific dollar amount of a particular security, rather than being forced to buy whole shares (which can be costly for many of these larger companies with high stock prices).

Be sure to consider the various fees charged by a broker versus direct investment plans (a few of these can be costly as well, so don’t just assume a DRIP is cheaper).

If you don’t have thousands to invest, or even if you do, consider starting a DRIP and adding any extra dollars you can squeeze from your budget towards and income-replacer later on. If twenty years from now you could live a frugal lifestyle on passive dividends you’ll be glad you started.

Disclaimer: At the time of this writing, I do not own the individual stocks (PG, KO, XOM, BP) mentioned in this article

An easy way to increase your investment returns is to pay more attention to the expenses you are incurring. Even seemingly small savings can result in a notable increase in your long-term profits. More importantly, every dollar you save in expenses is a dollar increase in your net worth.

Keep in mind, however, that investing involves finding a balance between the potential for making money and the potential for losing money, and expenses are no different. This is why you should always compare the costs you incur against the value you are receiving.

In some circumstances, higher expenses may be warranted. In others, they are an unnecessary transfer of wealth out of your portfolio.

I recommend reviewing all of your investing expenses on an annual basis. There are five primary areas to look at: brokerage commissions, taxes, trading costs, fund fees and advisory/custodial fees.

Brokerage commissions – These are the fees you pay to buy or sell a security. In general, lower fees are better, though you should consider the other services provided by the brokerage firm. For example, it might be worth paying a few extra dollars per trade if the brokerage firm provides good research, access to useful online tools, or offers certain conveniences that you find to be of value.

Taxes – Capital gains and dividend taxes reduce the actual profit you realize. Though the new tax law extends low rates, taxes still lower your true return. Short-term capital gains are even more expensive. Whenever possible, hold your least tax efficient investments (e.g. dividend-paying stocks) in your IRA and your most tax efficient investments (e.g. municipal bonds) in your regular brokerage account.

Trading Costs – Also referred to as transaction costs, these are expenses incurred when a buy or sell order causes a security’s price to move. Trading costs are extremely low for an actively traded stock such as General Electric (GE) and are higher for a stock or bond that is not actively traded. In all cases, you should consider the average daily dollar volume (total number of shares times price per share) and how much money you are looking to invest.

It may be more profitable to place several small orders rather than one large order. You should also use limit orders to ensure your transaction is executed within the bid-ask spread (the price buyers are willing to pay and the price sellers are looking to receive).

Fund Fees – Both mutual funds and exchange-traded funds (ETFs) charge annual management fees. Mutual funds may also charge fees for buying (front load) or selling (back-end load) shares, as well as fees for marketing expenses. Since most mutual fund managers do not beat their benchmarks (e.g., the S&P 500), lower fees are preferable.

As far as ETFs are concerned, the free trading commissions offered by brokerage firms may not be justified if the annual expense is higher than a similar ETF that does not qualify for the waived commissions. Be sure to consider both the risk-adjusted performance and the diversification benefits a fund offers; a higher fee may be justified if a fund provides less volatility or allows you to invest in an asset class you are not already invested in.

Advisory/Custodial Fees – Some firms charge advisory, custodial or account maintenance fees. You may also pay separate expenses to consult with a financial advisor. These expenses can be justified if you are receiving quality advice, lower commissions, or provided access to other financial services. The more complicated your financial or tax situation is, the more you will need to spend on advisory fees. Furthermore, a good advisor is worth the expense if he can keep you on track to achieve your financial goals.

As stated above, you should review your investment expenses annually to determine whether you are receiving adequate value for them. In my book, Better Good than Lucky, I recommend keeping a trading journal that lists the reasons you bought and would consider selling the stocks, bonds and funds you hold in your portfolio. It is also a good idea to include a list of your investment fees and the reasons you think they are valid. Doing so will provide a checklist that can assist with your annual review. It’s simple, but very effective.

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%.

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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?

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.

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.