Taxes: How to Maximize Dividend Stock Earnings

What makes investing in dividend stocks so intriguing is the power of compound dividends. We all know that compound interest is what occurs when interest previously earned is added to the principle and is considered when calculating future interest – i.e. earning interest on interest. Compound dividends are like compound interest, but much better.

Like compound interest, reinvested dividends will earn “dividends on dividends”, but it doesn’t stop there. In addition, great income stocks grow their dividends each and every year, so that means your dividends are growing even if they were not reinvested.

As our detractors like to point out, there is a dark cloud that hangs over dividend stocks in the form of income taxes. Each year the government has their hand out wanting their cut of our dividend income. For most investors in the U.S. investing in stocks with qualified dividends the tax is limited to 15%. But still that is 15% that can’t be reinvested.

One way to minimize the negative effect of taxes is with the use of tax advantaged accounts, such as a Roth IRA, to house a portion of your income portfolio. The beauty of using your Roth IRA as an income investment account is that you will never have to pay taxes on the dividends earned. Avoiding the taxes will have a significant affect on your account balance over time.

Consider a hypothetical case where $3,000 is used to purchase three stocks each year for 10 years in a Roth IRA and a taxable account. The accounts are opened on the last trading day of 2008 while dividends and the the year’s contribution are reinvested on the last day of the year. I selected three dividend companies, Chevron Corp. (CVX) – Analysis, Consolidated Edison Inc. (ED) and Genuine Parts Co. (GPC) – Analysis, that grew dividends over the last 10 years. Here are the results of the analysis:

Value At Dec. 31, 2008
			Account Type
		IRA		Taxable		$Diff		% Diff
Chevron Corp. (CVX)		12,403.36		12,168.68		234.68		1.93%
Consolidated Edison Inc. (ED)		13,108.02		12,575.85		532.17		4.23%
Genuine Parts Co. (GPC)		14,395.88		13,993.27		402.6		2.88%
Total		39,907.26		38,737.81		1,169.46		3.02%

Click here to see the spreadsheet used to generate the above results.

The use of of a tax advantaged IRA saved this hypothetical portfolio $1,169.46 or 3.02%. Over time this difference would continue to grow, and would be quite substantial for a person that opened a Roth IRA in their 20’s and held it 40+ years into their 60’s at retirement.

Full Disclosure: Long CVX, ED, GPC. See a list of all my income holdings here.

Comments

[Vaun:]

Minor caveat: you are consistent in the article with mentioning this is the case for a Roth, but you might want to put it on the chart since with a Traditional you would pay income tax on the withdrawals whether it came from cap gains or dividends.

Sep 30 05:09 PM

[mbkelly75:]

I think a Roth is better for this than a traditional IRA because of the difference in the rules. A Roth also gives the benefit of being able to pass to heirs probate-free if set up correctly - sort of like a smaller easier trust fund - and this is something a traditional IRA can not do.

Oct 03 01:10 PM

[sdfsdf:]

Can some one explain to me if I can buy MLPS in Roth IRA and how are they taxed when bought within a Roth Account?

Oct 09 11:47 AM

[Falconflight:]

Very very helpful information. Thanks!

Oct 09 02:38 PM

[Snoball:]

Vaun
Re; "Minor caveat: you are consistent in the article with mentioning this is the case for a Roth, but you might want to put it on the chart since with a Traditional you would pay income tax on the withdrawals whether it came from cap gains or dividends."

Can't you "swap" out of equities in your IRA in anticipation of retirement? Sell your equities in non-taxable accounts and buy them in taxable accounts. It has the effect of acumulating tax free all the gains in equities and dividends. At retirement you pay taxes on the savings accounts in your IRA, which you would be doing anyway. The equities are now in taxable accounts but subject to cap-gains on a step up.

Snowball

Oct 28 02:40 PM