Maximize Qualified Dividends For Higher Returns

Jul. 19, 2019 3:10 PM ETVFIAX, VTMFX, VTCLX, VTMSX9 Comments

Summary

  • Portfolios that emphasize qualified dividends can boost after-tax returns without additional risk.
  • Many index funds offer a 100% qualified dividend payout rate.
  • Qualified dividends and long-term capital gains help the wealthy realize a lower tax rate than the middle class.

The media gives so much attention to maximizing investment returns through stock and fund selection that individual investors often overlook lower hanging fruit: Qualified Dividends.

What Are Qualified Dividends?

According to Investopedia, a qualified dividend is:

a dividend that falls under capital gains tax rates that are lower than the income tax rates on unqualified, or ordinary, dividends. To qualify for the maximum tax rates of 0%, 15% or 20% that apply to long-term capital gains, qualified dividends must meet the following requirements, as outlined by the Internal Revenue Service (IRS):

  1. The dividend must have been paid by a U.S. company or a qualifying foreign company.
  2. The dividends are not listed with the IRS as those that do not qualify.
  3. The required dividend holding period has been met.

A maximum dividend tax rate of 20% compares favorably to ordinary dividends which can be taxed as much as 37% (the top marginal income tax bracket). Because after-tax returns ultimately represent the actual returns realized by an investor, strategies that place an emphasis on maximizing qualified dividends can improve after-tax returns while adding negligible portfolio risk.

Why Should I Care About Qualified Dividends?

Qualified dividend strategies can help investors of all income levels avoid significant taxes while negligibly affecting portfolio risk. When used in combination with long-term capital gains, extremely wealthy individuals can lower their tax rate to even below what the typical middle-class American pays. Because the wealthy derive most of their income from investment gains and dividends, which are potentially subject to long-term capital gains and qualified dividend tax rates, many are able to bypass the top bracket of 37% in favor of a lower 20% bracket. Warren Buffett was famously quoted as saying that he realizes a lower tax rate than his secretary:

Counting payroll taxes, I'll probably be the lowest paying taxpayer in the office. -Warren Buffett

Qualified dividends only affect after-tax returns and thus, only have value within taxable accounts. Even so, a qualified dividend maximization strategy is one of many industry-accepted ways investors can construct portfolios, and such a strategy can also be used in tandem with other strategies such as value-tilt or momentum strategies. Some investors may even choose to pursue dividend minimization strategies which attempt to limit their tax burden by investing in companies that pay low dividends or none at all.

Now, before the comments section gets flooded with dividend-crazed investors crying foul, it should be clearly stated that:

Dividends are not a free lunch!

Companies that choose to distribute excess cash in the form of a dividend will see their stock price reduce by the amount of the dividend on the payout date. If all recipients choose to reinvest their dividends back into the stock, then there will be no difference between a dividend and lack thereof with one important difference:

A dividend creates a taxable event for the investor.

Taxable events mean additional taxes which reduces after-tax returns.

How to Implement a Qualified Dividend Strategy

For those interested in a qualified dividend maximization strategy, an investor should attempt to maximize the percentage of qualified dividends paid out for stocks, mutual funds, and ETFs located within taxable accounts.

Many mutual funds and ETFs offer a 100% qualified dividend rate meaning that 100% of the dividends paid out during a fiscal year were qualified. Vanguard, in particular, publishes an annual listing of the qualified dividend percentages for all of their mutual funds and ETFs during a fiscal year. (Year-end Qualified Dividend Income 2018). Most Vanguard index funds such as the Vanguard 500 Index Fund (VFIAX) offer a 100% qualified dividend rate during most years. Vanguard also offers tax-managed index funds (VTMFX, VTCLX, VTMSX) which attempt to lower investor's tax bills by combining a qualified dividend maximization strategy with a dividend minimization strategy.

Investors with access to both taxable and tax-exempt accounts can shelter their small-cap and international funds (which tend to pay lower percentages of qualified dividends) within tax-exempt accounts and hold 100% qualified dividend large-cap domestic funds within taxable accounts for an optimal tax-efficient asset location. With only a taxable account, investors can reasonably approximate a total market portfolio by using a combination of Vanguard's (or other's) tax-managed index funds which can provide a large share of total market exposure.

This article was written by

I'm a portfolio manager for a large pension fund specializing in quantitative investment strategy and risk.  I hold the CFA charter,and an M.S. and B.S. in engineering from Georgia Tech.

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.

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