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Among dividend investors, where is it best to hold dividend stocks has become a frequent topic of debate. So here's the question: you have cash to invest in dividend stocks, do you:

  1. Pay income tax on the cash, and invest the rest in a taxable account; or do you
  2. Invest the entire amount of cash in a tax-sheltered account (IRA/401K/etc)?
You might think that you should hold dividend stocks in a taxable account, because then the dividends would be taxed at the rate for qualified dividends, rather than be taxed at the rate for ordinary income. But it turns out you would be better off if you hold dividend stocks in a tax-sheltered account.
I’ll start out by providing a specific example, then widen out my perspective to try to arrive at a general rule. Here's the example:
You begin with $11,000. You are in the accumulation phase of your life. During the accumulation phase:
  • Your income tax rate is 33%.
  • The dividend tax rate is 15%.
  • The dividend yield on your stocks is 6%.
You accumulate for 19 years.
Scenario #1: If you invest in a taxable (i.e. “unsheltered”) account, then you pay 33% income tax on the initial $11,000, leaving you only $7,370 to invest. You pay 15% on the dividends you receive each year. You will end up with $18,963.53:
| unsheltered | unsheltered | unsheltered | unsheltered
year | starting | + growth | - tax | = ending
---- | ------------ | ------------ | ------------ | ------------
1 | $ 7370.00 | $ 442.20 | $ 66.33 | $ 7745.87
2 | $ 7745.87 | $ 464.75 | $ 69.71 | $ 8140.91
3 | $ 8140.91 | $ 488.45 | $ 73.27 | $ 8556.09
4 | $ 8556.09 | $ 513.37 | $ 77.00 | $ 8992.46
5 | $ 8992.46 | $ 539.55 | $ 80.93 | $ 9451.07
6 | $ 9451.07 | $ 567.06 | $ 85.06 | $ 9933.08
7 | $ 9933.08 | $ 595.98 | $ 89.40 | $ 10439.66
8 | $ 10439.66 | $ 626.38 | $ 93.96 | $ 10972.09
9 | $ 10972.09 | $ 658.33 | $ 98.75 | $ 11531.66
10 | $ 11531.66 | $ 691.90 | $ 103.78 | $ 12119.78
11 | $ 12119.78 | $ 727.19 | $ 109.08 | $ 12737.89
12 | $ 12737.89 | $ 764.27 | $ 114.64 | $ 13387.52
13 | $ 13387.52 | $ 803.25 | $ 120.49 | $ 14070.28
14 | $ 14070.28 | $ 844.22 | $ 126.63 | $ 14787.87
15 | $ 14787.87 | $ 887.27 | $ 133.09 | $ 15542.05
16 | $ 15542.05 | $ 932.52 | $ 139.88 | $ 16334.69
17 | $ 16334.69 | $ 980.08 | $ 147.01 | $ 17167.76
18 | $ 17167.76 | $ 1030.07 | $ 154.51 | $ 18043.32
19 | $ 18043.32 | $ 1082.60 | $ 162.39 | $ 18963.53
Scenario #2: If you invest in a tax-sheltered (i.e. “sheltered”) account, then you pay no income tax on the initial $11,000, leaving the entire amount available to invest. You pay no tax on the dividends you receive each year. You will end up with $33,281.59:
| sheltered | sheltered | sheltered | sheltered
year | starting | + growth | - tax | = ending
---- | ------------ | ------------ | ------------ | ------------
1 | $ 11000.00 | $ 660.00 | $ 0.00 | $ 11660.00
2 | $ 11660.00 | $ 699.60 | $ 0.00 | $ 12359.60
3 | $ 12359.60 | $ 741.58 | $ 0.00 | $ 13101.18
4 | $ 13101.18 | $ 786.07 | $ 0.00 | $ 13887.25
5 | $ 13887.25 | $ 833.23 | $ 0.00 | $ 14720.48
6 | $ 14720.48 | $ 883.23 | $ 0.00 | $ 15603.71
7 | $ 15603.71 | $ 936.22 | $ 0.00 | $ 16539.93
8 | $ 16539.93 | $ 992.40 | $ 0.00 | $ 17532.33
9 | $ 17532.33 | $ 1051.94 | $ 0.00 | $ 18584.27
10 | $ 18584.27 | $ 1115.06 | $ 0.00 | $ 19699.32
11 | $ 19699.32 | $ 1181.96 | $ 0.00 | $ 20881.28
12 | $ 20881.28 | $ 1252.88 | $ 0.00 | $ 22134.16
13 | $ 22134.16 | $ 1328.05 | $ 0.00 | $ 23462.21
14 | $ 23462.21 | $ 1407.73 | $ 0.00 | $ 24869.94
15 | $ 24869.94 | $ 1492.20 | $ 0.00 | $ 26362.14
16 | $ 26362.14 | $ 1581.73 | $ 0.00 | $ 27943.87
17 | $ 27943.87 | $ 1676.63 | $ 0.00 | $ 29620.50
18 | $ 29620.50 | $ 1777.23 | $ 0.00 | $ 31397.73
19 | $ 31397.73 | $ 1883.86 | $ 0.00 | $ 33281.59
There’s no surprise here – if you don’t have to pay taxes, then you end up with more (in this case, almost twice as much) money.
That’s what happens during the 19-year accumulation phase. What about the withdrawal phase?
During the withdrawal phase:
  • You withdraw $7,000 per year after taxes.
  • Your income tax rate is 33%.
  • The dividend tax rate is 15%.
  • The dividend yield on your stocks is 6%.
The unsheltered account runs out of money in the third year:
| unsheltered | unsheltered | unsheltered | unsheltered | unsheltered
year | starting | + growth | - withdrawal | - tax | = ending
---- | ------------ | ------------ | ------------ | ------------ | ------------
1 | $ 18963.53 | $ 1137.81 | $ 7000.00 | $ 170.67 | $ 12930.67
2 | $ 12930.67 | $ 775.84 | $ 7000.00 | $ 116.38 | $ 6590.13
3 | $ 6590.13 | $ 395.41 | $ 7000.00 | $ 59.31 | $ -73.77
The sheltered account has almost $10,000 left after the third year:
| sheltered | sheltered | sheltered | sheltered | sheltered
year | starting | + growth | - withdrawal | - tax | = ending
---- | ------------ | ------------ | ------------ | ------------ | ------------
1 | $ 33281.59 | $ 1996.90 | $ 7000.00 | $ 2310.00 | $ 25968.49
2 | $ 25968.49 | $ 1558.11 | $ 7000.00 | $ 2310.00 | $ 18216.60
3 | $ 18216.60 | $ 1093.00 | $ 7000.00 | $ 2310.00 | $ 9999.59
The conclusion: paying income tax during the withdrawal phase leaves you with more money than paying income tax during the accumulation phase.
Is this conclusion a specific case based on the particular numbers I used in the example, or is it a more general case?
I wrote a computer program to try each of the following cases:
(1) The initial dividend stock purchase ranges in $1,000 increments from $1,000 to $22,000
(2) Years of accumulation ranges in 1 year increments from 1 to 40
(3) Net income during withdrawal ranges in $1,000 increments from $1,000 to $10,000
(4) Income tax rate during accumulation and withdrawal phases is one of 10%, 15%, 25%, 28%, 33%, 35%
(5) Dividend tax rate is either 0% or 15%
(6) The dividend yield ranges in 1% increments from 0% to 10%
There are a total of 6,969,600 cases.
Please note that this is not a Monte Carlo simulation. There is no randomness here.
Each case can end in one of 4 states:
(1) The two accounts run out of money in the same year (a “tie”)
(2) The unsheltered account runs out of money before the sheltered account (a “sheltered win”)
(3) The sheltered account runs out of money before the unsheltered account (an “unsheltered win”)
(4) Neither account runs out of money during 50 years of withdrawals, so it is a “tie at 51 years”
How did the 6,969,600 cases turn out?
  • 55% were ties
  • 38% were sheltered wins
  • 7% were unsheltered wins.
For each of the 50 withdrawal years, the number of sheltered wins was greater than the number of unsheltered wins.
For each of the 50 withdrawal years, the number of sheltered wins was between 5 and 7 times greater than the number of unsheltered wins.
When the accumulation phase income tax rate was 28%, 33%, or 35%, the unsheltered account never won – the income tax paid at the beginning is so high, and the starting stock purchase is correspondingly so low, that subsequent growth is stunted. The 28% bracket begins with a taxable income of $82,400.
To see the program itself and further statistical breakdowns and example cases, click here.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Source: Why You Should Hold Your Dividend Stocks in Tax-Sheltered Accounts