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With consumer price inflation, as measured by the Consumer Price Index, running at 2% year-over-year and 10 year treasury yields at 1.6%, investors cannot even keep up with inflation by investing in treasury bonds. Therefore, many have turned to dividend paying stocks to help keep up with rising prices. This can be a good strategy and I have been recommending many dividend growth stocks such as Coca-Cola (NYSE:KO), Johnson & Johnson (NYSE:JNJ), Exxon (NYSE:XOM), Wal-Mart (NYSE:WMT), and Procter & Gamble (NYSE:PG) for a long time.

But beating inflation with dividend paying stocks isn't as simple as some might think. In taxable accounts it's not enough to just find stocks that have dividends growing faster than the rate of inflation. It turns out that in a taxable account, if inflation is high enough investors are very likely going to lose money over time. Let's look at an example of a stock that has a total return of 4% per year due to dividends while the inflation rate is running at 3%. The dividends are taxed at 15% each year, all dividend payments are reinvested back into the stock and the investor holds onto this stock for 10 years. We will also, for the sake of simplifying the example, assume the stock price doesn't move during this time. Using my publicly available calculator called Total Returns- Dividends vs. Price Appreciation, along with some calculations in a spreadsheet, I came up with the following outputs below:

Year

Div
Payment

Dollars

Taxes

Net
Dollars
After
Taxes

Total Return
After Taxes

Total Return
10 Yrs

Cumulative
Inflation

Real TR
Over 10 Years

0

-

10,000

1

400

10,340

60

10,340

3.4%

x

3%

x

2

414

10,692

62

10,692

3.4%

x

6%

x

3

428

11,055

64

11,055

3.4%

x

9%

x

4

442

11,431

66

11,431

3.4%

x

13%

x

5

457

11,820

69

11,820

3.4%

x

16%

x

6

473

12,221

71

12,221

3.4%

x

19%

x

7

489

12,637

73

12,637

3.4%

x

23%

x

8

505

13,067

76

13,067

3.4%

x

27%

x

9

523

13,511

78

13,511

3.4%

x

30%

x

10

540

13,970

81

13,970

3.4%

40%

34%

5%

Over 10 years this stock sees a total return of 40%. But after taking into account inflation over this time period, the real total cumulative return is only 5% (barely 0.5% per year). In other words, half of the real return expected due to the dividend yield being 1% point higher than inflation is taken by taxes.

As inflation increases, the problem becomes worse. In fact, once inflation hits 6%, the investor will actually lose money over a 10 year time frame in real terms if we assume the total return (before taxes) from dividends will always be 1% point higher than the inflation rate.

Year

Div
Payment

Dollars

Taxes

Net
Dollars
After
Taxes

Total Return
After Taxes

Total Return
10 Yrs

Cumulative
Inflation

Real TR
Over 10 Years

0

-

10,000

1

700

10,595

105

10,595

6.0%

x

6%

x

2

742

11,225

111

11,225

6.0%

x

12%

x

3

786

11,893

118

11,893

5.9%

x

19%

x

4

833

12,601

125

12,601

5.9%

x

26%

x

5

882

13,351

132

13,351

5.9%

x

34%

x

6

935

14,145

140

14,145

6.0%

x

42%

x

7

990

14,987

149

14,987

6.0%

x

50%

x

8

1,049

15,878

157

15,878

5.9%

x

59%

x

9

1,111

16,823

167

16,823

5.9%

x

69%

x

10

1,178

17,824

177

17,824

5.9%

78%

79%

-1%

Why is it that the real return declines as inflation goes up? The reason is that in order to pay the taxes on the dividends, more of the gains from the dividend payment have to be used. Taxes due to inflation are very sneaky that way. They eat into real returns: the higher the rate of inflation, the more in percentage terms that is lopped off of the real total return.

The examples seen here show us why investments that generate income or dividends every year, and then are taxed at the end of the year, generally belong in tax-deferred accounts if possible. Holdings that generate mostly capital gains that can be deferred until the stocks are sold should generally be held in a taxable account.

Let's look at the same example above where this stock is in a tax-deferred account and the rate of inflation is once again 6%.

Year

Div
Payment

Dollars

Taxes

Net
Dollars
After
Taxes

Total Return
After Taxes

Total Return
10 Yrs

Cumulative
Inflation

Real TR
Over 10 Years

0

-

10,000

1

700

10,700

-

10,700

7.0%

x

6%

x

2

749

11,449

-

11,449

7.0%

x

12%

x

3

801

12,250

-

12,250

7.0%

x

19%

x

4

858

13,108

-

13,108

7.0%

x

26%

x

5

918

14,026

-

14,026

7.0%

x

34%

x

6

982

15,007

-

15,007

7.0%

x

42%

x

7

1,051

16,058

-

16,058

7.0%

x

50%

x

8

1,124

17,182

-

17,182

7.0%

x

59%

x

9

1,203

18,385

-

18,385

7.0%

x

69%

x

10

1,287

19,672

-

19,672

7.0%

97%

79%

18%

This looks quite a bit better. The real return is 18% over the 10 year time period. But what can be done if you have already maxed out what you can put into your tax-deferred accounts?

Although most people understand that capital losses can be used to offset capital gains, they don't realize that there is a way to help offset dividends as well. There is a strategy that I have used myself whereby I take my stocks with the highest dividend yields and I buy them on the ex-dividend date and sell them the day before the next ex-dividend date. This way I get all of the price increase due to dividends, but in the form of capital gains. Because I sell on the ex-dividend date, I receive no dividends at all. At the end of the year I can offset these capital gains with capital losses I incurred years ago and effectively pay no income tax on my gains. I wrote about this strategy recently here.

I don't recommend trying this strategy with multiple stocks at once. It would end up being a lot of work and the trading fees will add up. But you could use this for a select few individual stocks or a strong dividend paying ETF such as the Dow Jones Select Dividend ETF (NYSEARCA:DVY), which has a dividend yield of 3.5%.

Source: Can You Beat Inflation With Dividends?