3 Ways To Pay Your Yearly Dividend Income Tax Bill

by: Willow Street Investments

Summary

The reinvestment of dividends greatly benefits an investor’s returns as they grow older and move towards their retirement years.

Investors who reinvest their dividends will benefit from the power of compounding - a “snowball effect” that happens when your earnings generate even more earnings.

As powerful an investing method as dividend reinvestment is, an ever-increasing dividend income tax burden is an obligation that an investor must plan for and meet over time.

From our vantage point, there are only 3 methods of addressing a dividend income tax burden as an investor moves forward in their investment lives.

To meet a dividend income tax burden, an investor may switch between no dividend reinvestment, total dividend reinvestment or hybrid dividend reinvestment (depending on their life stage).

Dividend reinvestment is a popular method for investors to grow their equity portfolios and to provide tax-advantaged income in retirement. With respect to individual stocks and mutual funds, dividend reinvestment involves the use of dividend distributions from stocks or mutual funds to purchase additional shares. Reinvestment of dividends when an investor is young greatly benefits such investor’s returns (including their total dividend payout) as they grow older and move towards their retirement years. In other words, investors who reinvest their dividends will benefit from the “power of compounding.” What is the benefit of compounding? The Vanguard company, the innovator in the low-cost index fund arena, explains the “power of compounding” concept well:

“The key is the power of compounding, the snowball effect that happens when your earnings generate even more earnings. You receive interest not only on your original investments, but also on any interest, dividends, and capital gains that accumulate—so your money can grow faster and faster as the years roll on. This is particularly evident in retirement accounts, where principal is allowed to grow for years tax-deferred or even tax-free.

Here's an example:

Let's say you begin with two separate $10,000 investments that each earn 6% a year (keep in mind this is a hypothetical example, and actual returns would likely be different and a lot less predictable). In one $10,000 investment, you withdraw your investment earnings in cash each year, and the value of your account stays steady[.] In the other investment, you don't cash out your earnings—they get reinvested. … If you keep reinvesting the earnings (and again, we're assuming a steady hypothetical return of 6% each year) after 20 years your investment will have grown by more than $20,500. And if you've got an even longer time frame—for example, if you're in your 20s and saving for retirement—after 40 years, your investment will have grown by more than $92,000.”

Dividend reinvestment can be a powerful method for investors to build a steady stream of income for retirement (whenever such retirement occurs). Historically, the total return of the S&P 500 has been slightly more than nine percent per year. About half of such total S&P 500 return has come from share price appreciation and the other half from dividends. So, as we can see, the role of dividends is significant with respect to total returns. As noted in the title of this article, however, this article involves the tax burden investors must continually meet in their years of dividend reinvesting until they decide to take their dividends in cash without any reinvestment whatsoever. From our vantage point, we see that there are only 3 methods of addressing a dividend income tax burden. Although such methods may seem obvious, we still consider it important to briefly address each of them.

1) No Reinvesting of Dividends at All

This method of meeting dividend income tax obligations is the most radical of all methods. This method is radical because it defeats much of the “snowball effect” benefit that an investor reaps from decades of dividend reinvesting. As such, an investor should avoid the no-dividend-reinvestment method to meet their dividend income tax burden until they reach at least 3 decades of dividend reinvesting and/or retirement (whichever comes first). An investor should reinvest as much of their dividends for as long as they can meet their dividend income tax burden through work-related income.

2) Full dividend reinvestment

This is the preferred method of allocating dividends towards furthering total investment returns through share price appreciation and an increasing dividend income stream. As noted, throughout this article full dividend reinvestment is easier said than done given increasing tax burdens that result from an increasing dividend income stream (in a taxable account of course). For example, let us use the U.S. Federal tax rate for qualified dividends of 15 percent along with a state income tax rate of 7 percent. As such, an investor living in such a state would owe 22 percent in taxes every year on their dividend income. For $50,000 in yearly dividend income, an investor would owe $11,000 in taxes in any given year. For $100,000 in yearly dividend income, an investor would owe $22,000 in yearly taxes.

As one can see then, as dividend income grows the more difficult it becomes for an investor to meet their dividend income tax burden with work-related income alone. With that said, however, a successful dividend re-investor must use this method for as long as they can to maximize their retirement funds and their yearly dividend income. Depending on when a dividend re-investor begins their dividend reinvestment journey, their dividend income tax burden may become excessive sometime in their 50s or 60s. At such “breaking point,” an investor must decide whether they will turn off their dividend reinvesting in total or use a hybrid dividend reinvesting method as noted below.

3) Hybrid dividend reinvestment

This is the most likely method an investor will use to pay their dividend income tax burden as they age. An investor may employ this method in retirement or as they approach retirement to meet their ever-increasing dividend income tax burden. There are a number of ideas that come to mind when using a hybrid reinvestment technique. For example, an investor can shut off dividend reinvestment for their largest equity positions and/or their largest individual equity streams. In addition, an investor may turn off their dividend reinvestment for their equities that have become moderately to highly over priced (while continuing to reinvest dividends in stocks with a depressed share price due to temporary business setbacks).

Given the ease that an individual investor may turn on and off dividend reinvestment in one or more of their stocks in a modern day brokerage account, they can continually readjust their hybrid dividend reinvestment strategy to meet their dividend income tax burden through harvested cash dividends and whatever work-related income an investor has. While we continue to reinvest all of our dividends, our dividend tax burden increases by the year and we too are determining when we will begin to employ a “hybrid” dividend re-investing plan. Our estimate is that we will reinvest our dividends for about 5 to 7 more years (or at 60 to 63 years old) as we estimate that by such time our dividend tax burden will become too large to meet by work-related income alone.

Conclusion

An investor should not approach dividend reinvestment with an “auto-pilot” approach. While discount brokerages make dividend reinvestment an almost effortless task, an investor should continue to review all of their investments to make sure: 1) they do not keep reinvesting dividends in a failing company; 2) they do not keep reinvesting dividends in the shares of company that has become too large of a holding in an overall portfolio (ie, 15 percent or more of a total portfolio); 3) they do not keep reinvesting dividends in the shares of a company that has become grossly overpriced; and 4) they can funnel off some of their dividends as they grow older to help pay off some of the taxes owed by them on their yearly dividends. Dividend reinvestment is not an “all or nothing” idea. Today, an investor can reinvest their dividends in some of their stocks and not reinvest dividends in their other stocks at any given point in time for the reasons just stated.

Regardless of an investor’s efforts in building the value of their stock portfolio and resultant dividend-income stream, taxes remain in the background as a yearly constant obligation that such investor must address. In fact, the more successful a dividend re-investor becomes, the greater their tax burden becomes. During an investor’s working years, they need to assess on a yearly basis just how they intend to meet their dividend tax obligations. As noted above, an investor can just turn off their dividend reinvestments in total and pay about 20 or so percent of such income as estimated taxes throughout the year. As also noted, a more preferable method to meet such tax obligation is to pay a tax obligation with work-related income for as long as one can until the burden becomes too heavy. Finally, when the tax burden becomes too heavy an investor should meet their dividend tax burden through a mix of dividend and work-related income to meet their tax burdens without unduly relying on work-related income.

The younger an investor is when they begin their dividend reinvestment journey, the sooner they will have to deal with an ever-growing dividend tax burden “problem.” Of course, such a “problem” is a good problem in many ways and may be referred to as a “first-world problem” by intellectuals in the world. It is a problem nonetheless that we are beginning to address as this article is being published. To date, we have been making monthly estimated Federal and New York State tax payments for the first 10 or so months of the last few years, but we are unsure of how many more years we can meet our tax burden just from our work-related earnings. In our case, we can meet our dividend income tax burden with work-related income for perhaps five or so more years. Then, we will need to employ a hybrid dividend reinvestment method to meet our growing dividend income tax obligations.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.