I have been bothered by the notion of many commentators on Seeking Alpha saying they only have their DGI stocks in their IRAs or 401(k)'s. Is the tax deferral worth it in the end? Tax deferral does not equal tax avoidance and with the ways the tax laws are written for at least the next 80 days or so, if your IRA (and I will use IRA from here on out) is substantial, you will have to finally pay the piper upon withdrawal from the IRA.
The other part that has bothered me is that being a high income earner (which I have no regrets about), I don't get the advantage of placing money in a Roth, paying the taxes now, and letting things grow tax-free. So back to the question which I tried to answer myself: Is tax deferral for dividend growth stocks really worth it?
To answer this question, I tried to minimize the variables down to one: Is there a realistic chance of someone holding one stock for 25-30 years and letting it ride, reinvesting dividends along the way? Using our esteemed colleague, David Crosetti, I decided Coca-Cola (NYSE:KO) was a company that many families could have held through thick and thin for decades. Having gone to "Coca-Cola University" in Atlanta, (a.k.a. Emory), Coke bleeds through the entire state of Georgia, and there are many millionaires made because of the Coke association.
With our stock chosen, I tried to create what may be a (minimal variable) pseudo-realistic scenario. A 40-year-old male, married with no kids and a single income household, makes $25,000 in 1982. For the next 25 years, his salary increases with inflation at 3.5% (I know the early 1980s was nowhere close to 3.5%) where when the gentleman retires at the end of 2006 at 65, he is making almost $60,000.
At the end of 1981, he received $20,000 as an inheritance and puts it all in our one stock of Coke and reinvests the dividends the entire time (575.5 shares at a closing price of $34.75). To make the numbers easier, I annualized the dividend and reinvested on December 31 of each year. (Yes, I realize the amount of shares and overall value will be less than the true quarterly compounding, but this was hard enough to calculate already.)
Two other key points, which make this scenario more difficult than I initially realized: First, all taxes for dividends were paid from the person's salary and not removed from the investment. (This will make life easier when we compare this to having the same $20,000 invested in KO in an IRA because no money moved in or out of the account). Second, the tax rates considered were the historical rates on dividends and did not look into the entire financial picture of this individual. In other words, I am only interested in what the tax consequence was of just having these dividends in a taxable account and nothing else.
Needless to say, the investment worked out great. Over those 25 years, the CAGR of KO was 17.5% per year, turning our 575.5 shares into 23,547 plus shares at the end of 2006 and having a value of $1.14 million dollars from our one time investment of $20,000. But I want to focus on the dividend stream, since the goal for many of us in this section of SA will attempt to live off the income and not touch the principal.
|Age||Year||Dividends received||Tax rate||Dividend Tax||Cumulative||Salary (3.5%||dividend tax|
|39||1981||taxes paid||increase)||paid by salary|
|40||1982||$ 1,427.15||29.0%||$ 413.87||25000||1.60%|
|41||1983||$ 1,616.19||26.0%||$ 420.21||$ 834.08||$ 25,875.00||1.57%|
|42||1984||$ 1,747.62||25.0%||$ 436.90||$ 1,270.99||$ 26,780.63||1.58%|
|43||1985(24)||$ 1,956.97||25.0%||$ 489.24||$ 1,760.23||$ 27,717.95||1.71%|
|44||1986 (3:1)||$ 2,135.77||25.0%||$ 533.94||$ 2,294.17||$ 28,688.08||1.80%|
|45||1987||$ 2,363.43||28.0%||$ 661.76||$ 2,955.93||$ 29,692.16||2.15%|
|46||1988||$ 2,606.63||28.0%||$ 729.86||$ 3,685.79||$ 30,731.38||2.29%|
|47||1989(8)||$ 3,033.61||28.0%||$ 849.41||$ 4,535.20||$ 31,806.98||2.58%|
|48||1990||$ 3,631.78||28.0%||$ 1,016.90||$ 5,552.10||$ 32,920.23||2.98%|
|49||1991||$ 4,433.12||28.0%||$ 1,241.27||$ 6,793.37||$ 34,072.43||3.52%|
|50||1992||$ 5,233.84||15.0%||$ 785.08||$ 7,578.45||$ 35,264.97||2.15%|
|51||1993||$ 6,440.36||15.0%||$ 966.05||$ 8,544.50||$ 36,499.24||2.56%|
|52||1994||$ 7,500.03||15.0%||$ 1,125.00||$ 9,669.51||$ 37,776.72||2.88%|
|53||1995||$ 8,589.73||28.0%||$ 2,405.12||$ 12,074.63||$ 39,098.90||5.94%|
|54||1996||$ 9,876.74||28.0%||$ 2,765.49||$ 14,840.12||$ 40,467.36||6.60%|
|55||1997||$ 11,167.04||28.0%||$ 3,126.77||$ 17,966.89||$ 41,883.72||7.21%|
|56||1998||$ 12,065.16||28.0%||$ 3,378.24||$ 21,345.14||$ 43,349.65||7.53%|
|57||1999||$ 12,984.75||28.0%||$ 3,635.73||$ 24,980.87||$ 44,866.89||7.83%|
|58||2000||$ 13,947.88||28.0%||$ 3,905.41||$ 28,886.28||$ 46,437.23||8.13%|
|59||2001||$ 14,933.14||28.0%||$ 4,181.28||$ 33,067.55||$ 48,062.53||8.41%|
|60||2002||$ 16,845.75||27.0%||$ 4,548.35||$ 37,615.91||$ 49,744.72||8.83%|
|61||2003||$ 18,868.47||15.0%||$ 2,830.27||$ 40,446.18||$ 51,485.79||5.31%|
|62||2004||$ 21,813.23||15.0%||$ 3,271.98||$ 43,718.16||$ 53,287.79||5.93%|
|63||2005||$ 25,017.53||15.0%||$ 3,752.63||$ 47,470.79||$ 55,152.86||6.57%|
|64||2006||$ 28,467.56||15.0%||$ 4,270.13||$ 51,740.93||$ 57,083.21||7.23%|
|65||2007||$ 32,024.89||15.0%||$ 4,803.73||$ 59,081.12|
|66||2008||$ 35,792.53||15.0%||$ 5,368.88||$ 61,148.96|
|67||2009||$ 38,618.25||15.0%||$ 5,792.74||$ 63,289.18|
|68||2010||$ 41,443.98||15.0%||$ 6,216.60||$ 65,504.30|
|69||2011||$ 44,269.70||15.0%||$ 6,640.46||$ 67,796.95|
|70||2012||$ 48,037.34||15.0%||$ 7,205.60||$ 70,169.84|
I didn't have room to put the amount of shares and the dividend each year, so you will just have to take my word on its accuracy. There are three things that jumped out at me when doing this exercise.
The first thing I noticed is the tax rate on dividends were between 15% (the last 10 years) and up to 29% for this person's tax bracket. Obviously, the less taxes the better, but outside of the double taxation on dividends, I don't find 30% oppressive. Zero percent would be ideal, but I try and live in the real world at the same time.
The second item that jumps out as we go from left to right is the column "Cumulative Taxes Paid." So our theoretical 65 year old has paid nearly $52,000 on dividend taxes over the last 25 years holding Coca-Cola through thick and thin. Is this fair? I'll leave the moral argument alone. Is it a lot of money? Picking the right stock helped - versus, say, Worldcom or, more recently, GE (NYSE:GE) or Citigroup (NYSE:C) - to say I would gladly pay $52,000 to know I have a million dollar plus asset, but our gentleman has paid nearly as much in taxes over the last 25 years as his entire salary in 2006.
This brings me to my last point, which may be the reason why this is highly unsustainable as our person grows older. The last column is the most telling. Since our person never touched the Coke stock, the only way he could pay the taxes on the dividends were from his salary. Just to pay the taxes was about 6-9% of his salary every year for the last twelve years, and that's not even including any other taxes he may encounter (his actual salary, real estate, sales tax, etc.) plus just the cost of living. This becomes an arduous task to try and enjoy life in the golden years as costs are hitting us from all angles. It's a reality that I don't think many of us youngsters were aware of, but I also am taking this out of a semi-realistic context of NEVER touching the stock. I think logic would prevail that some dividends will have to be removed and not reinvested in future shares to pay for the taxes on our ever growing income stream.
This has opened my eyes to see my dream of retiring in my late 40s may have to be delayed a few more years, but I have not given up hope that this is the right way of investing for me. I don't think this was an extreme example of an obscure stock that rocketed to the moon, but gives a more realistic picture (in a well defined bubble) of what dividend growth investing could end up looking like after 25 years. But we still have not spoken about the distribution phase of our life. If enough interest is shown, I will add Part 2: So which way is better? Tax deferral or dripping the taxes over time?