The Best Asset Location for Dividend Stocks
Mar. 22, 2011 12:30 PM ET9 Comments
Robert Allan Schwartz's Blog
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Dividend Investing, Dividend Growth Investing
Seeking Alpha Analyst Since 2010
I retired in November 2016 at age 60.
My personal investing goal is to own a portfolio of dividend growth companies such that:
1) The overall portfolio dividend income is sufficient to pay for all of my routine retirement expenses. I do not ever want to be forced to sell something to produce cash, especially when my asset prices are down. [I have no objection to occasionally choosing to sell something to pay for a one-time expense such as a vacation or a gift.]
and
2) The overall portfolio dividend income rises each year by more than the rate of inflation, so that my purchasing power does not erode over time.
I invest primarily in David Fish's lists of Dividend Champions, Dividend Contenders, and Dividend Challengers. See http://www.dripinvesting.org/tools for those lists.
I do not invest in MLP's or BDC's or CEF's or preferreds.
I maintain a free web site that contains dividend histories for all of David Fish's Dividend Champions, Contenders and Challengers: http://www.tessellation.com/dividends
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 1: [ http://www.tessellation.com/dividends/asset_location_tie.html ]
Here’s an example of state 2: [ http://www.tessellation.com/dividends/asset_location_sheltered_win.html ]
Here’s an example of state 3: [ http://www.tessellation.com/dividends/asset_location_unsheltered_win.html ]
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.
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