
Once a quarter or so, my mutual funds pay me a dividend and I get all excited. I see them on my online statements that look something like this:
“Hey Katie, look how much we got in passive income this month! That would pay for tons of our expenses even if we quit working. Isn't that awesome?”
“It sure is,” she agrees.
And then I sit back and remember what a dividend really is, and then I'm no longer so happy about it. In fact, I'm a little bit upset.
Revealing yourself as a dividend-focused investor is, in the words of Steve Adams, the “classic tell of the ignorant investor.”
The Dividend Community
Yet there are entire blogs, books, forums, Facebook groups, etc. all focused on buying shares of stock in order to get dividends. Let me share an example from a recent blog post from the Dividend Diplomats:
It's great, right? This investor only had $423 in dividends in 2011 but in 2019, received over $15,000! Clearly, he's on to something. Well, that's actually true. He is on to something. I am super happy for his success. But it has nothing to do with the dividends. So what is he on to exactly?
- He makes a lot
- He save a lot of what he makes
- He invests his savings in a reasonable way
- He lets compound interest work
But none of that has anything to do with the dividends.
What Is a Dividend?
Classically, a dividend is the payment you get for being an owner. It's your share of the profits. If the company you own was actually profitable after adding up all of its income and its expenses, it will often send you some of those profits in the form of a dividend. On average, US stocks pay a dividend of about 2%. Some pay more, some pay less, many pay none at all. If you own stocks in the manner that I recommend (via low-cost, broadly diversified index funds), all of those dividends get paid to the mutual fund. It uses the dividends to pay its expenses, then passes along the rest to you, usually about once a quarter.
Each profitable company has a decision to make with its profits. It can do one of five things with its profits:
- Let profits sit in its bank accounts
- Reinvest profits in the company—buy more factories, buy another company, do more research and development, do more marketing, etc.
- Buy back its own shares
- Send the money to the owners
- Give the money away to charity
Now we own a company, and we get to make these same decisions all the time. Sometimes we let the profits sit in the company bank accounts. Sometimes we take the money out of the company bank accounts and put it in our personal bank account. Sometimes we reinvest it in the company by hiring more people or buying additional services or equipment. Sometimes we give money away (see WCI Scholarship) but we generally just do that on the personal side. Since we already own the entire company, we can't buy back any shares.
All of the publicly traded companies (stocks) in the US face the same decisions. Some of them retain profits, some reinvest them, some buy back shares, and some pay dividends. Typically, a stock will do a little bit of each. The idea is that if the company does not have a better use for the money, it should send it back to the investors to be invested elsewhere.
The Taxation of Dividends
So why does it matter what the company does with that money? I mean, let's create a hypothetical company. Let's say there are 1 million shares of this company, each worth $100. Let's say the company had a pretty good year and made $8 Million dollars, or 8%. It is now worth $108 Million, or $108 per share. What are the consequences of the five options discussed above?
- Retained profits: The corporation will pay taxes on this money at corporate tax rates. Now shares may be worth $106 and company is worth $106 Million.
- Reinvested profits: No taxes due, as the profits disappear (they were put toward a business expense). Assuming the company made a good investment, shares are still worth $108 and company is still worth $108 Million.
- Stock buybacks: The corporation pays taxes on the money at corporate tax rates. It uses the $6 Million left to buy shares of stock at $106 a share. It buys back 56,604 shares, leaving 943,396 shares. The company is now worth $100 Million, but the shares are worth $106 a share.
- Dividend: The corporation pays taxes on the earnings at corporate tax rates. It sends the $6 Million left to the investors. The company is worth $100 Million. Shares are worth $100 a share. An owner of one share now has $6 in cash and $100 in shares, for $106 total. However, the owner now pays taxes on the dividend, perhaps $1 per share, and is left with $5 in cash and $100 in shares, for $105 total. If investing in a tax-protected account, the investor would have $106 total, of course.
- Charity: The corporation gives the $8 Million away to charity. The investors revolt, the stock price craters, and the company becomes worth just $25 Million and shares are worth $25. (In reality, a C Corp can deduct a charitable gift of up to 10% of its adjusted gross income [25% in 2020] but actually, corporations only give about 1% of earnings on average.)
As you can see, after tax, the best option for the investor is for the company to reinvest its profits. ($108/share total). Next best is to simply retain the profits or use them to buy back shares ($106/share total). Paying out dividends is the fourth best option ($105/share total). Giving the money away is the worst option ($25/share total).
So now explain to me why so many investors get excited about getting a dividend? Yes, you should be excited that your company is making money. But no, you should not be excited that the company is actually giving it to you.
As you can see, a dividend is really just a mandatory, taxable return of capital.
How Much Income Do You Want?
Let's step back out of the corporate world for a minute and talk about your own personal little financial world. I want to do a little thought experiment. I want you to ask yourself how much income you want. Go ahead, think about it. At first glance you might say, “As much as I can get.” But when you think about it some more, you will come up with the correct answer, which is that you do not want any income at all. Income means taxes. The less income you receive, the less you pay in taxes. If you spend $100,000 a year, and you pulled that out of your checking account, you have zero income, pay zero in taxes, and still got to spend $100,000 a year. Awesome, right? But not very realistic.
More realistically, you want your income to be about equal to your spending. If you earn $400,000 a year, but spend $100,000 a year, you will pay taxes on $400,000. If you earn $100,000 a year, you can still spend $100,000, but you only have to pay taxes on $100,000.
“Yes,” you might object, “but I would still have that other $300,000 less taxes (perhaps $75,000) and getting $325,000 is better than getting $100,000.”
But what if I told you that I would still compensate you $400,000, but $300,000 of it would be deferred, meaning you do not yet have to pay taxes on it. In fact, you wouldn't have to pay taxes on it until you spend it years or even decades from now. And, it would continue to grow in this tax-protected way. In fact, if you never spend it, your children will get it, and the taxes will never have to be paid. Interested? Of course you would be.
But a company that pays dividends is basically telling you, “I don't care that you don't need all this income right now. I'm going to make you take it and pay taxes on it anyway.” That's not very nice of them, is it? And you shouldn't be excited about the fact that they're treating you this way, much less bragging about it on Twitter or your blog.
For the last 15+ years, my income has been higher than my spending. It would be awesome to defer all of that income until I actually needed to spend it, letting compound interest continue to work on it in a tax-protected manner. But a dividend investor is somehow trying to argue just the opposite. It's a pretty weak argument.
Declare Your Own Dividend
But if you don't get paid dividends, how will you get income when you do need it? I mean, stocks only pay 2% dividends on average but you know you can take out about 4% of your nest egg a year to spend in retirement. Well, it turns out you can “declare your own dividend” any time you want. You simply sell shares. Those shares get long-term capital gains treatment (i.e. taxes are exactly equal to those of qualified dividends). Except you get to choose when you get that income and pay those taxes. Those years or even decades of tax-deferral boost your returns further than if you had to sell some every year, pay taxes on it, and then (possibly) pay a commission or bid/ask spread to reinvest it (i.e. what dividend investors are so excited about doing).
The Dividend Counter Argument
As you can see, per financial theory, dividends are not a good thing. All else being equal, it would be better for the company to reinvest its profits and for you to “declare your own dividend” at some point down the road than to get dividends every year. However, it would be facetious of me not to address one other point that dividend investors make. They argue that “all else is not equal.” They argue that companies that pay dividends are better companies to invest in. They argue that corporations can fudge the numbers on their financial statements, but they can't fudge dividends. Dividends are cold, hard cash. They may even argue that corporations do not reinvest profits well, and the owners would be better off getting those dividends even after paying taxes on them, but that argument is dramatically weakened by the fact that so many of them participate in DRIPs (Dividend Reinvestment Plans). Here's an example of that argument:
The very long-term data, limited as it is, does suggest that value companies outperform growth companies. That hasn't been the case for 10 plus years now, but I suspect they still will over my investment horizon. One mark of a value company is that it tends to pay higher dividends. Essentially, the company is not growing as quickly and does not have a great way to reinvest its earnings so it pays them out to investors. So a dividend investor generally has a “value tilt” in their portfolio. That's not such a bad thing if you think value stocks will outperform growth stocks in the long run. But even if you believe that, Larry Swedroe would argue that dividend yield is not necessarily the best measure of value or even another related “factor”, quality. He likes price to book value as a metric rather than dividend yield.
At any rate, at best a dividend focus done in a tax-protected account isn't going to hurt you much and may even help compared to a total market approach if value stocks outperform. At worst, you'll fall prey to taking uncompensated risk (i.e. individual stock risk that can be diversified away) and pay more in taxes than you had to, slowing your path to financial independence, all while looking financially illiterate every time you talk about how awesome your dividends are.
Bottom line: Don't bother rejoicing when you see the dividends roll in each quarter. You don't need dividends for compound interest to work on your investments, and they're producing a tax drag on your taxable portfolio that isn't helping matters.
What do you think of dividends? Do you tilt toward them? Were you surprised to learn they are really just a return of capital?
One might say that instead of you selling securities, the company is actually selling part of itself to give you the dividend. So having a portfolio where you take a 4% withdrawal rate, consisting of 2% dividend yield and 2% of sales is really not radically different than taking a 4% dividend where the company is, in essence selling off 4% of itself to you in the form of a dividend. Despite having known the basic mechanics of all this for years, it really is sinking in much more deeply with this post and all the resulting comments. I think the only wild card here is psychology, that being investor psychology. I even find myself thinking that a dividend is like interest and that it buoys the stock price. Actually I suppose a high dividend yield can bully the stock price a bit, but at the end of the day if that dividend is threatened at all the stock price of a high-yielding stock plummets faster than anything else.
Hi Jim,
I am at a loss.
For my tax advantaged retirement accounts, the dividends are reinvested, which I assume is fine.
For my taxable account, which I am creating with Vanguard now asks me if I want to reinvest my dividends and capital gains or place it in the money market. For tax purposes what should I do (to minimize my tax burden?)
Thank you
Same tax burden either way, but I generally recommend sending dividends to your sweep account and reinvesting them manually with your monthly investments to avoid wash sales and tiny tax lots.
nice try, but research shows dividend paying stocks tend to outperform over time.
last time I’ll turn to an MD for investing advice.
https://csinvesting.org/wp-content/uploads/2012/06/high-dividends-research-by-tweedy-browne.pdf
Can’t imagine that the good people at the “Tweedy, Browne Worldwide High Dividend Yield Value Fund” would possibly have any conflict of interest in recommending dividend paying stocks
No. Not when you compare on a risk adjusted basis.
https://www.etf.com/sections/index-investor-corner/swedroe-vanguard-debunks-dividend-myth?nopaging=1
I think the jury is still out on that as to whether the outperformance of value is a risk thing or a behavior thing. Probably a combination of both, but who knows which makes a larger contribution.
Yup. It’s one way (although probably not the best way) to get a value tilt and value stocks have outperformed in the long run.
I guess we’ll never see you around here again then.
Hi Jim,
Does it matter when you reinvest dividends in taxable automatically vs when you do so manually in terms of qualified vs non qualified dividends taxation? I am confused. In other words: when do you exactly pay dividends taxes?
-Right after it is paid to you?
-When you reinvest it?
When you open a brokerage account and start getting dividends, does it mean you will always get a 1099-DIV and pay dividends taxes regardless of what you do with the dividends (automatically reinvest, invest manually later, let it sit in your settlement fund, transferring to your bank later)? If yes how does the qualified vs non qualified dividends come to play.
I am totally confused.
Thanks.
Qualified vs non qualified has to do with how long you hold the stock around the ex-div date (60 days or more = qualified), not whether it is reinvested or not.
The 1099-DIV comes once a year and those taxes would be covered by quarterly estimated payments if large enough and just when you settle up in April if not too large.
A lot of really good information here.
Say that one is fortunate enough to have started dividend investing early enough, so that by retirement, the dividends paid from dividend stocks are equal to, or less than your monthly or yearly living expenses. Yet, the amount is within the 0% capital gains tax rate for a married couple filing jointly.
I thought that’s what the whole point of dividend investing was – to get enough qualified income in dividends to support living expenses, but low enough so that minimal or no taxes have to be paid on them. Our CPA mentioned last year that she could set us up with a plan so that we pay zero taxes in retirement. So, that’s my personal goal. Our living expenses (mortgage, insurance, utilities, food) are around $40,000/yr.
I currently have no dividend income outside of a tax deferred retirement account and Roth IRA, both of which hold low expense index funds.
I’m not making an argument, just trying to understand better, in case I may be missing something.
Thank you!
Why is your goal to pay zero taxes in retirement rather than to have as much as possible after taxes are paid? Seems odd. It can be done, but I would argue you give up too much to do it.
Personally, I don’t want to be in the 0% qualified dividends bracket in retirement because that means I have less than $84K in taxable income and I prefer spending a lot more than that.
But can that be done? Sure. If that’s your goal, knock yourself out. You should be aware, however, that if all you ever spend is your dividends you will have ended up spending far less than you could safely spend without running out of money. Your heirs will thank you.
Please see the attached chart in this article, where dividends make a difference.
https://mapsignals.com/map-blog/dividends-make-the-difference/
https://mapsignals.com/wp-content/uploads/2022/02/100-dollar-in-SP-500-dividend-investment-growth.png
And also on Bogle’s thoughts on dividends.
https://m.economictimes.com/markets/stocks/news/dividends-are-the-best-friends-of-stock-investors-john-bogle/articleshow/66344112.cms
Nobody is arguing dividends don’t matter. The argument is that one shouldn’t be focused on them.
1) this chart shows the difference of reinvesting dividends vs not reinvesting, not the impact on the holding value if the firms weren’t issuing dividends in the first place and instead committing capital back to their own operations to grow the company
2) of course dividends matter because it’s on that basis, at least partly, that all stock valuations are decided. If you took equity in a company and never saw any cash flows you might be a little hesitant to invest. How many S-Corp partners here don’t ever see owner distributions?
*Of course WCI replied before I could, with greater brevity and precision.
Does this change in retirement? My wife just retired with a $1.4 million 401K, rolled into an IRA. I’m still working but have cut 457 contributions substantially to make up for the loss of her income. The IRA is currently almost all in cash from the rollover and are trying to determine what low cost fund to put it in (currently at Fidelity). We’ll need about $40K annually from this account to continue living the lifestyle we want. At this point, I don’t see that dividends matter from a tax perspective….everything I pull out will be taxed regardless of where it comes from. She won’t be investing more money (other than the returns exceeding $40K per year. We’ll be well over the $84K MAGI. Not that I would invest strictly in dividends, but having some dividend producing investments does seem to offset some sequence of returns risk, and feels like a reasonable thing to do. Am I missing something?
Slightly. If you’re spending the money anyway, then you’re probably paying something in taxes for it. But even then, if you could sell shares instead, “declaring your own dividend” some of that will be principal, and thus not taxable. So even then, it’s more tax-efficient to not have stocks paying dividends.
But inside retirement accounts none of this matters. Dividends, no dividends. Who cares? If it’s in a Roth account it comes out tax-free, if it’s in a tax-deferred account it comes out at ordinary income tax rates whether it pays dividends or not.