Perhaps the biggest disadvantage dividend seekers face is the double taxation by the US government. Before shareholders see a dime of profits, Uncle Sam takes a bite from corporations' earnings. Then he gets his seconds from investors by way of the dividend tax. To show how this works, I am going to use a hypothetical company that pays out 100% of its post-tax earnings in dividends. Company ABC has $1,000 in pre-tax earnings and because it decided to hire cheap accountants without any creativity, its corporate tax rate is 35%. So that leaves $650 to distribute to shareholders. If dividend taxes remain at 15%, then that leaves $552.50 left for shareholders after tax, which is an effective tax rate of 44.75%. Not exactly encouraging for the average dividend investor.
Thankfully for most of us, there are ways to grow wealth while getting around some of this taxation. If your Adjusted Gross Income (AGI) is less than $112,000 for 2013, you should be taking advantage of a Roth IRA. If you do not have a Roth IRA yet, I highly recommend maxing out your contribution before investing anywhere else. The maximum contribution for 2013 is $5,500, but if you did not put any money into a Roth IRA in 2012, you can contribute an additional $5,000 up until April. The downside to being able to let your money earn tax-free income is that you will not be able to withdraw it until you are 59 ½, but if your investing horizon goes out that far, then there is no better place to keep your money.
Let's assume Sally Saver determines she will be able to invest $10,000 after taxes. After talking to an investment advisor, Sally decides she only wants to invest in dividend champions because she feels that a reliable, growing income stream would be the best thing for her when she retires. The stocks she chooses for her Roth IRA are 3M Company (MMM), Archer Daniels Midland (ADM), ExxonMobil Corp. (XOM), McDonald's Corp (MCD), Wal-Mart Stores Inc. (WMT).
|Company||Investment||Dividend||5-year avg DGR|
With this bucket of 5 dividend champions, Sally is able to use her $10,000 to get a diversified dividend income stream of $266 a year. But this is only for the first year. Since Sally has purchased companies with a long history of raising dividends, she can expect a growing income stream year over year without ever adding to her investment. Using an average dividend growth rate of 9.44% (for the sake of simplicity), Sally can expect her dividend payments over the next 10 years to look something like this:
As we can see, the total value of dividends collected over 10 years in Sally's Roth IRA is $4,126, which gives her an annualized 4.1% return on her investment from the dividends alone. This means that even if the stock price of these 5 companies is exactly the same 10 years from now as it is today, Sally is still able to grow her money faster than the current rate of inflation. Now let's take a look at Sally's dividend payments if her investments were not in a tax-sheltered account (assuming the 15% dividend taxes).
The total value of her dividends is now only $3,507, lowering her annual return to 3.5%. Keep in mind that this example does not take into account the value of reinvested dividends. If Sally reinvests her dividends every year the results favor the Roth IRA even more. Another point to consider is whether or not we will see dividend taxes rise in the near-future. While some of the uncertainty around dividend taxes was resolved with recent tax bill, there has been a call to do away with the dividend tax rate and to determine dividend taxes based on individuals' tax brackets. With the next round of political compromise required in two months, you can bet that dividend taxation will be an ongoing topic of conversation. Since Sally invested in a Roth IRA, she can have peace of mind knowing that she does not have to worry about having Uncle Sam take a drink from her income stream.
Roth IRAs are an amazing way for low-to-middle income earners to build wealth for retirement. I have had multiple professors and mentors tell me that retirement is a thing of the past, and that the majority of my generation will have to work until up until the day they die. I intend to be able to retire by age 59 ½, and my Roth IRA will help me do just that.
Disclosure: I am long XOM.