"In this world nothing can be said to be certain, except death and taxes."
- Benjamin Franklin
Taxes. We have to pay them, but we don't have to like it.
Dividend growth investors are especially vulnerable to taxes. Or at least it appears that way before taking a deep dive into the numbers.
First things first, let's throw down the baseline. This article assumes the individual has the highest tax burden possible. This means, the highest tax bracket in the United States without using any type of retirement account.
This way we can examine the 'worst case scenario' of investing in dividend stocks and taxation.
Here are the numbers:
- Non-qualified dividends tax rate: 39.6%
- Qualified dividend tax rate: 20.0%
- Short-term capital gains tax rate: 39.6%
- Long-term capital gains tax rate: 20.0%
The first thing that stands out is the difference between qualified and non-qualified dividends and short and long-term capital gains.
What Are Qualified Dividends?
Qualified dividends are dividend payments taxed at the long-term capital gains rate. To be 'qualified', a dividend must:
- Be paid by a United States company or a qualified foreign company
- Dividend must be paid from a 'qualified' investment
- Shares must be held for more than 60 days before the ex-dividend date for common stocks
This begs the question, what is a 'qualified' investment? Most publicly traded stocks are qualified. The exceptions are REITs and MLPs.
The Lesson: Invest in normal common stocks for more than a few months to cut your dividend tax bill nearly in half.
Now that that's out of the way, we can move on to the difference between long-term and short-term capital gains rates.
What's The Difference between Long-Term & Short-Term Capital Gains Rates?
The difference could not be simpler. Long-term capital gains rates apply to investments held for more than 1 year. Short-term capital gains rates apply to investments held for less than one year.
The Lesson: Hold your investments for more than 1 year to cut your capital gains tax bill nearly in half.
The Tax Benefit of Long-Term Investing
Warren Buffett is a long-term investor. He will hold some businesses for decades. Case-in-point: He first bought American Express (NYSE:AXP) in 1964.
Fun Fact: Henry Wells and William Fargo founded both American Express (In 1850) and Wells Fargo (NYSE:WFC) (in 1852).
There's a reason Buffett holds for the long run (and it isn't blind loyalty). When you don't sell, you don't pay capital gains tax. An example is below to illustrate this point.
There are two investors. One finds a business that compounds his wealth at 9% a year, year after year (American Express has total returns of 8.9% a year since June of 1972, which is first available data in Yahoo Finance). He never has to sell, and his investment pays no dividends. At the end of 20 years, he sells his stock and pays capital gains.
The next investor invests in a different business every year (just long enough to get long-term capital gains tax treatment). His investments also grow at 9% a year, but he buys and sells every year. This hypothetical investor also has excellent insider connections, because he pays no brokerage fees or slippage in this hypothetical example. At the end of 20 years, he goes to cash (he has paid capital gains every tax every year).
At the end of 20 years, here's the score for every $1 invested:
- Investor 1 has $4.68 for an 8.0% CAGR
- Investor 2 has $4.02 for a 7.2% CAGR
The image below shows their growth in wealth over time:
The reason for the dip in value in year 20 for investor 1 is he is paying his 'back' capital gains tax (while investor 2 has paid them every year).
The buy and hold investor has beaten the buy and sell investor by 0.8 percentage points a year. The buy and sell investor would have to average before-tax returns of just above 10% a year to keep pace with the buy and hold investor's investment averaging before tax returns of 9% a year.
How did investor 1 outperform? He allowed the money he would have been paying to good old Uncle Sam compound in his account by not selling.
This money investor 1 is not paying taxes on is essentially an interest-free loan from the government. It becomes sizeable as time goes by. At the end of 20 years (just before he sold and paid capital gains taxes), this investor would have $9,209 in 'tax free government loans' working for him from a $10,000 initial investment. The math is below:
- Initial investment of $10,000
- $10,000 grows to $56,044 at 9% over 20 years
- ($56,044-$10,000) = Capital Gains Taxable Amount = $46,044
- $46,044 x 20% Tax Rate = $9,209
The next year, this 'tax-free government loan' (if it grew at 9% again) would've made the investor an extra $829 in profit if he didn't sell.
The higher the interest rate and the longer the holding period, the more pronounced the gains from this 'tax-free government loan' will be.
The Lesson: Invest in businesses that will compound your wealth for long periods of time. Short-term investments should offer significantly better total return potential than long-term investments for total return optimizing investors with taxable accounts.
The Tax Disadvantage of Dividend Investors
The long-term average returns of the stock market are around 9% a year. Let's take our two investors above again. This time, they've both decided to invest for the long-run. Both only sell 1 time, after 20 years of holding.
Investor 1 invests in a stock that grows its earnings-per-share at 6% a year, and pays a 3% qualified dividend. The company grows its dividend payments at 6% a year, and Investor 1 reinvests all dividends with 0 frictional costs (lucky him or her!).
Investor 2 invests in a stock that grows its earnings per share at 9% a year, and pays no dividends.
Both stocks have total returns of 9% a year before taxes. Their after-tax returns are shown below:
- Investor 1 has $4.50 for a CAGR of 7.8%
- Investor 2 has $4.68 for a CAGR of 8.0%
You can download a spreadsheet with the dividend calculations here for those wanting to look at the math behind this.
The non-dividend buy and hold investor has beaten the dividend reinvesting investor by 0.2 percentage points a year.
The dividend investor's stock would have to grow at just above 6.2% a year (and have a dividend yield of 3%) to keep pace with the non-dividend investment growing at 9% a year.
Don't Write Off Dividend Investing Just Yet
The dividend investing example above isn't realistic. In the real world, stock prices fluctuate. When a dividend paying stock's price declines (and the dividend isn't cut), yield rises.
This means dividend investors who are reinvesting dividends will be buying back more stock at the most opportune times - when share prices are lower. This effect alone will likely boost returns past the non-dividend paying stock.
The higher a stock's price volatility (combined with the ability to pay steady or increasing dividends), the greater the gains from this effect.
Dividend reinvesting forces you to buy more when stock prices decline; a 'buy the dips' strategy. On top of a 'buy the dips' boost, dividend-paying stocks have also historically outperformed the market.
The image below shows how all quintiles of dividend stocks have outperformed non-dividend paying stocks. The 2 highest yielding quintiles have outperformed by 3.12 and 2.18 percentage points a year, respectively.
Click to enlarge
Source: Dividends: A Review of Historical Returns by Heartland Advisors
Investors looking to minimize their tax burden in taxable accounts (and who wouldn't?) should look to invest in great businesses for the long-run.
The trade-off between holding for years (and hopefully even decades) versus selling holdings every year is much larger than the trade-off between investing in dividend paying and non-dividend paying stocks.
Dividend paying stocks are tax disadvantaged relative to non-dividend paying stocks in a hypothetical world where they have the same expected returns.
Historically, medium to high yield dividend paying stocks have averaged total returns of 2 percentage points to 3 percentage points a year above non-dividend paying stocks. It is not logical to trade 2 to 3 percentage points in returns in exchange for 0.2 percentage points of tax benefits.
Said another way, the superior expected total returns of dividend paying stocks more than makes up for their slightly worse tax burden, even in the highest tax rate accounts.
In conclusion, investors looking to maximize long-term total returns should look for high quality dividend paying businesses trading at fair or better prices. The Dividend Aristocrats and Dividend Kings lists are excellent places to find such businesses.
These businesses should have strong and durable competitive advantages that you expect to continue far into the future. It is critical to not overpay for great businesses. Value always matters. Holding period and reinvesting dividends matters a great deal as well in the world of taxes in which we live.