Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

The Best Asset Location for Dividend Stocks

No, the title is not mis-spelled; we are not talking about asset ALLOCATION (i.e. what percent of your assets should be allocated to dividend stocks?), but asset LOCATION: Is it better to hold dividend stocks in a taxable (i.e. unsheltered) account or in an IRA/401K/etc tax-sheltered account?
The “conventional wisdom” suggests holding dividend stocks in a taxable account, because the dividends would be taxed at the (2010) rate for qualified dividends (either 0% or 15% [ http://en.wikipedia.org/wiki/Dividend_tax ]), rather than be taxed at the (2010) rate for ordinary income (10%, 15%, 25%, 28%, 33%, 35% [ http://www.moneychimp.com/features/tax_brackets.htm ]).
Is the conventional wisdom correct?
There are 3 factors that are completely within your control:
(1)    How much cash do you want to spend right now to purchase dividend stocks?
(2)    How many years do you accumulate before you begin to withdraw?
(3)    How much net (i.e. after-tax) income do you want to receive each year you withdraw?
There are 4 factors that are not completely within your control:
(1)    What is your income tax rate while you accumulate?
(2)    What is the dividend tax rate?
(3)    What is the annual dividend growth rate?
(4)    What is your income tax rate while you withdraw?
What is the effect of asset location?
I wrote a computer program (in the C language) [ http://www.tessellation.com/dividends/asset_location_program.html ] to compute the effect for each of the following cases:
(1)    Cash spent right now ranges in $1,000 increments from $1,000 to $22,000 inclusive [www.pensionrights.org/publications/fact-... ]
(2)    Years of accumulation ranges in 1 year increments from 1 to 40 inclusive
(3)    Net income during withdrawal ranges in $1,000 increments from $1,000 to $10,000 inclusive
(4)    Income tax rate during accumulation is one of 10%, 15%, 25%, 28%, 33%, 35%
(5)    Dividend tax rate is one of 0%, 15%
(6)    Annual dividend growth rate ranges in 1% increments from 0% to 10% inclusive
(7)    Income tax rate during withdrawal is one of 10%, 15%, 25%, 28%, 33%, 35%
There are 22 * 40 * 10 * 6 * 2 * 11 * 6 cases, for a total of 6,969,600 cases.
Please note that this is not a Monte Carlo simulation – you make your 3 choices, you decide on the asset location, and every other combination of factor values is tried. There is no randomness here.
I do make some simplifying assumptions:
(1)    During all accumulation years, you pay the same income tax rate.
(2)    During all withdrawal years, you pay the same income tax rate (but this rate is not necessarily the same as the accumulation years’ income tax rate).
(3)    The dividend tax rate never changes during each case.
(4)    The annual dividend growth rate never changes during each case.
When you start, the tax-sheltered account always begins with a larger amount, because you didn’t have to pay income tax on that amount. For example: if you are in the 25% income bracket, and you have $20,000 to spend, the tax-sheltered account will begin with $20,000, but the taxable account will begin with $15,000 (after you’ve paid $5,000 in income tax). Reducing the initial amount by the amount of the income tax is a significant hurdle for the taxable account to overcome.
During the accumulation years:
(1)    A taxable account’s balance grows by the dividend growth rate
(2)    A taxable account pays the dividend tax rate on that growth
(3)    A tax-sheltered account’s balance grows by the dividend growth rate
(4)    A tax-sheltered account pays 0 dividend tax on that growth
The tax-sheltered account will always have a larger balance during accumulation, because it pays no tax on the growth. Reducing the growth by the amount of the dividend tax is a significant hurdle for the taxable account to overcome.
During the withdrawal years:
(1)    A taxable account’s balance grows by the dividend growth rate
(2)    A taxable account pays the dividend tax rate on that growth
(3)    A taxable account pays 0 withdrawal income tax on the amount of the withdrawal
(4)    A tax-sheltered account’s balance grows by the dividend growth rate
(5)    A tax-sheltered account pays 0 dividend tax on that growth
(6)    A tax-sheltered account pays the withdrawal income tax rate on the amount of the withdrawal
It “costs” more to withdraw income from the tax-sheltered account, because you have to pay income tax on it when you withdraw it. Reducing the balance by the amount of the income tax is a significant hurdle for the tax-sheltered account to overcome.
Which hurdle leaves you with the most money?
Each case can end in one of 4 states:
(1)    The two accounts run out of money in the same year (a “tie”)
(2)    The unsheltered account runs out of money before the sheltered account (a “sheltered win”)
(3)    The sheltered account runs out of money before the unsheltered account (an “unsheltered win”)
(4)    Neither account runs out of money during 50 years of withdrawals, so my program gave up and called it a “tie at 51 years”
Here’s an example of state 4: [ http://www.tessellation.com/dividends/asset_location_tie_at_51_years.html ] Note that you invested $22,000, once, perhaps at age 25, and then 40 years later, at age 65, with no subsequent investments, and with the growth coming completely from dividends and none from capital gains, your account is worth $995,703.50. Don’t I wish I could go back in time and show this to my 25-year-old self!
How did the 6,969,600 cases turn out?
Number of tests: 6969600
 
     |              | unsheltered |    sheltered
year |         ties |         wins |         wins
---- | ------------ | ------------ | ------------
   1 |       873105 |        24483 |       148395
   2 |       809422 |        43995 |       276269
   3 |       477953 |        44951 |       301948
   4 |       245270 |        40393 |       276929
   5 |       131713 |        36901 |       231164
   6 |        78388 |        32861 |       191340
   7 |        48743 |        28273 |       158253
   8 |        32327 |        24638 |       132213
   9 |        22568 |        21322 |       110303
  10 |        16259 |        17279 |        93255
  11 |        11773 |        14946 |        80154
  12 |         9109 |        13318 |        69413
  13 |         7245 |        11569 |        61964
  14 |         5533 |        10300 |        53988
  15 |         4347 |         9312 |        48562
  16 |         3796 |         8428 |        42191
  17 |         2887 |         7530 |        37330
  18 |         2321 |         6552 |        34094
  19 |         1925 |         5592 |        28982
  20 |         1577 |         5179 |        27527
  21 |         1246 |         4406 |        24431
  22 |          994 |         4268 |        21406
  23 |          928 |         3898 |        20246
  24 |          764 |         3333 |        17194
  25 |          594 |         3075 |        16980
  26 |          502 |         2707 |        14964
  27 |          434 |         2507 |        13482
  28 |          353 |         2358 |        11970
  29 |          352 |         2133 |        12205
  30 |          273 |         1925 |        10436
  31 |          234 |         1691 |         9181
  32 |          183 |         1495 |         8642
  33 |          165 |         1504 |         9001
  34 |          153 |         1314 |         7713
  35 |          129 |         1301 |         7074
  36 |          116 |         1063 |         6297
  37 |          129 |         1031 |         6100
  38 |           85 |         1089 |         5676
  39 |           69 |          989 |         4946
  40 |           82 |          916 |         5073
  41 |           54 |          799 |         4405
  42 |           65 |          731 |         4514
  43 |           43 |          619 |         3733
  44 |           39 |          692 |         3437
  45 |           34 |          625 |         3171
  46 |           33 |          645 |         3719
  47 |           16 |          438 |         2900
  48 |           23 |          439 |         2688
  49 |           18 |          387 |         2585
  50 |           16 |          403 |         2136
  51 |      1048031 |            0 |            0
 
1,048,031 out of 6,969,600, or 15%, are ties through 50 years.
2,794,387 out 6,969,600, or 40%, are ties after 50 years.
3,842,418 out of 6,969,600, or 55%, are ties.
2,670,579 out of 6,969,600, or 38%, are sheltered wins.
456,603 out of 6,969,600, or 7%, are unsheltered wins.
There are more than 5 times as many sheltered wins as unsheltered wins.
For each of the first 50 years of withdrawal, there were far more sheltered wins than unsheltered wins.
I was not expecting this result.
I wondered if there was some pattern for the unsheltered wins.
I computed frequency distributions on the various factors.
How much cash do you want to spend right now to purchase dividend stocks?
The first column is the frequency, the second column is the value:
 4866  1000
 8715  2000
11184  3000
13879  4000
16505  5000
18069  6000
19165  7000
20411  8000
21602  9000
22818 10000
22345 11000
23577 12000
22677 13000
23285 14000
24273 15000
24803 16000
25574 17000
26513 18000
26539 19000
27165 20000
26044 21000
26594 22000
 
I found no useful information here.
How many years do you accumulate before you begin to withdraw?
The first column is the frequency, the second column is the value:
12988  1
12880  2
12850  3
12867  4
12731  5
12676  6
12494  7
12565  8
12422  9
12420 10
12448 11
12479 12
12366 13
12356 14
12359 15
12400 16
12347 17
12214 18
12300 19
12022 20
11910 21
11628 22
11515 23
11331 24
11185 25
11120 26
10950 27
10733 28
10445 29
10318 30
10193 31
10096 32
 9864 33
 9715 34
 9516 35
 9412 36
 9279 37
 9202 38
 9096 39
 8911 40
 
I found no useful information here.
How much net (i.e. after-tax) income do you want to receive each year you withdraw?
The first column is the frequency, the second column is the value:
59005  1000
60521  2000
56106  3000
50231  4000
45769  5000
42276  6000
38768  7000
36952  8000
35077  9000
31898 10000
 
I found no useful information here.
What is the annual dividend growth rate?
The first column is the frequency, the second column is the value:
44560  0
47516  1
47867  2
47328  3
47623  4
47196  5
44035  6
39686  7
34620  8
30219  9
25953 10
 
I found no useful information here.
What is the dividend tax rate?
The first column is the frequency, the second column is the value:
361514  0
 95089 15
 
Clearly, unsheltered accounts do better when you don’t pay tax on dividends. What a surprise! (Not. )
What is your income tax rate while you accumulate?
The first column is the frequency, the second column is the value:
271647 10
175237 15
  9719 25
 
Note that when the income tax rate was 28%, 33%, or 35%, the unsheltered account never won. The 28% bracket begins with a taxable income of $82,400.
What is your income tax rate while you withdraw?
The first column is the frequency, the second column is the value:
 21375 15
 80784 25
 96774 28
119040 33
138630 35
 
Note that when the income tax rate was 10%, the unsheltered account never won. The 10% bracket ends with a taxable income of $8,375.
If you find any errors in my logic, my calculations, or my program, please let me know.
I can’t claim that this article definitively answers the asset location question for everyone, but it does for me – I’ve moved all my dividend stocks into a tax-sheltered account.


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