In a previous article I ran a 30 year backtest on 40 Dividend Champions and compared the returns to the S&P 500. The results, although skewed by survivor bias, demonstrated that dividend growth investing can show impressive returns. A key component to the dividend growth investing strategy is to buy and monitor. Having a strategy to execute on the buy and monitor approach is key to achieving similar results that are shown in the backtest study.
Tax Rate Uncertainty
One item that everyone can agree upon is that taxes will negatively impact returns. Currently qualified dividends are taxed at 15%, but starting in 2013 the tax rate on dividends will be equal to your ordinary income tax rate. For the highest tax bracket this will be 39.6%. This is a massive hike in taxes on dividends. One of the questions that immediately comes to mind for me, is what will the impact be on my portfolio?
If you have any of your dividend paying stocks in taxable accounts you will be impacted by the change in tax rates. How much you are impacted will depend on what your ordinary income tax rate is. One of the ways that we can understand how taxes impact our returns is to apply varying tax rates to a historical portfolio. I will use the same portfolio that was created in the previous backtest article to apply the different tax rates to.
Backtest Results
I had two options in the software program on how the taxes would be paid. The first option was to pay the taxes out of pocket. This caused the net investment amount to keep increasing to pay the taxes on the portfolio. This of course is not a realistic simulation as most wouldn't have another source of income to pay the taxes. The second option was to pay the taxes by sale of shares. I went with this option as it is the more realistic option. The software program in this scenario reinvests the dividend and then sells enough shares to cover the taxes.
The first graph below demonstrates the impact on our final portfolio value with a varying tax rate:
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You can see that it is a negative linear relationship between the tax rate and final portfolio value. This relationship should be expected as we will not have the full dividend payment to reinvest. The 3 key data points on the chart in my mind are:
- 0% tax rate - $25.2M
- 15% tax rate - $22.8M
- 39.6% tax rate - $18.1M
Going from a 15% tax rate to a 39.6% tax rate drops our final portfolio value at the end of 30 years by $4.7M or ~21%. This is quite a large decrease in the final portfolio value due to the tax policy change. My investment strategy is to have my dividend growth portfolio be my source of income in retirement. This tax change, if held constant for the next 30 years and assuming I am at the highest bracket, means that I would see a ~21% decline in my income during retirement. Depending on the size of your portfolio this decline could be a devastating hit to your income.
I was also interested in the tax rate impact on the annualized return. The chart below shows an exponential relationship between the tax rate and the annualized return on our portfolio:
(click to enlarge)
For those that prefer a data table to charts please see the table below:
(click to enlarge)
Conclusion
It is said that there are two things certain in life: death and taxes. Understanding what the impact taxes will have on your portfolio is the first step in being able to minimize these impacts. Planning for retirement and managing your portfolio does not stop when you retire. In fact I believe that in our later years it is even more critical to tightly manage your portfolio or have someone that you trust do it for you. Not having enough income to support your basic needs, especially in our later years, is something that I hope none of us have to experience.
Managing your portfolio in the most tax efficient way possible is key to maximizing your income. Every individual will have different considerations to take into account with their investing income strategy. There is no one size fits all strategy. There are some general guidelines to follow such as maximizing the usage of tax shelters like a 401k or IRA. Always have a plan in place and closely monitor it. Understand what variables are going to impact your plan and what the impact of that variable is. Buy and monitor is one of the key terms used when implementing a dividend growth strategy. I feel that it should not just be applied to the individual holdings but to all variables that will impact your portfolio value.
Additional disclosure: The disclosure applies to the companies in the backtest.
