Selling Shares Beats Collecting Dividends

When I described my drawdown strategy in early retirement, I stated we will “sell from the taxable account first.” I also plan to collect quarterly dividends from my index funds, but if Vanguard were Burger King and I could have it my way, I’d hold the dividends and take bites out of my account only as needed.

When I discuss the downsides of dividends, note that I am only referring to receiving dividends in a plain old brokerage account, a.k.a a taxable account. Anything that happens in a tax advantaged account like a traditional or Roth IRA, 401(k) or similar with regards to dividends, capital gains, buying or selling occurs without tax repercussions. In a taxable account, one must be cognizant of the consequences with regards to taxation.

 

I love dividends!

 

Well, not exactly, but I do tilt toward dividend paying stocks in my portfolio. I simply do so in my Roth IRA. Value stocks tend to be more likely to pay a dividend as compared to growth stocks, and I own Vanguard’s small cap and mid cap indexes in my Roth IRA. I also own the REIT index fund in Roth, which pays a higher dividend (trailing twelve month yield of 3.76%) than many dividend focused ETFs and mutual funds.

I’m an index fund investor. Those index funds actually pay dividends. In fact, when you compare the S&P 500 ETF  to the ProShares Dividend Darlings ETF, you’ll see remarkably similar dividend yields of 1.94% and 1.96% respectively. You’ll also see very similar returns. The biggest difference is in the fees, with the Proshares ETF costing investors nearly nine times as much (0.04% versus 0.35%). That’s an argument for buying the individual stocks rather than the ETF, I suppose.

It is fun to see the dividend income grow along with your portfolio. Truly passive income without so much as lifting a finger.

Dividends are one component of total return from an investment (the other being capital appreciation) and I like a good total return. I certainly wouldn’t want to give up a portion of my returns. If companies are paying dividends, I’ll certainly take them.

Dividend investors share data that show dividend payers have higher total returns than the total stock market, while some studies show the exact opposite.

While I believe it depends on the timeframe you choose to analyze, and that survivorship and hindsight bias play a role, I also believe that any edge (a.k.a. alpha) that exists rapidly disappears in a reasonably efficient market, and I’m content with the return of the indexes. We may also be seeing a value premium, a term that describes the slightly better performance of value stocks as compared to growth stocks that has persisted over long stretches of time and diverse geography.

 

I hate dividends!

 

Dividends create tax drag on my portfolio. Over the course of the year, the index funds I own will kick out roughly 2% in qualified dividends. I not only pay the 15% capital gains tax on those, but also a state income tax of 9.85% and the NIIT (ACA) surtax of 3.8% for a total of 28.65%.

With a 2% dividend, that’s  a tax drag of $573 for every $100,000 invested. I can expect to pay over $7,000 in taxes based on those dividends this year.

If I made 7-figures in California, my qualified dividends would be taxed at about 36% or $720 annually for every $100,000 invested in a taxable account with an average 2% qualified dividend.

And don’t get me started on ordinary (non-qualified) dividends. Those are taxed at your marginal tax rate, or somewhere between 40% and 50% or more for many high income households. Last year, all of Vanguard’s S&P 500 fund’s dividends were qualified, but about 7% of the Total Stock Market Fund and nearly 25% of my international funds’ dividends were taxed at that lofty ordinary income tax rate.

An ideal allocation in a taxable account would be broadly diversified and pay as little dividend as possible. Vanguard has tax managed funds which attempt to do this, but with higher fees than the corresponding index funds that may negate some or all of the benefit. Additionally, tax loss harvesting becomes difficult when you don’t have suitable partners that are similarly tax managed.

I’ve written about my favorite stock, Berkshire Hathaway, and the fact that it has not only performed very well for decades, but also has the benefit of zero tax drag because it pays no dividends. There are rumblings that this wonderful feature could be going away at some point. I would view a dividend from my BRK.B as an unwelcome change.

 

Why Selling Shares Is Better

 

When you invest in a taxable account, you should plan to buy and hold. But the day will come when you want to spend some of that money. You may access that money to make a big purchase during your working years, in which case you’ll want to sell the shares with the smallest percentage gains, as I recently did.

The most common scenario for my audience, however, is living off the money in a taxable account in early retirement.


Would you rather own stocks and funds that automatically pay you enough in dividends to cover your spending needs or own funds that pay little to no dividend, forcing you to sell shares?

Let me explain why you I much prefer the latter, assuming the total return of the two options is equal.

When you sell shares, you get to decide which shares to sell. Be sure to set your “cost basis” to “Specific ID” or the equivalent. Having purchased shares over a number of years, you may have some shares that have quadrupled in value and others that have only appreciated 10% or not at all. If you’re selling shares to “create your own dividend,” you can also determine the tax impact of acquiring those dollars.

If you’re in danger of being bumped into a higher tax bracket, particularly the 25% federal income tax bracket in which capital gains taxes are levied, you can sell those shares that will give you very little capital gains. If you’re well below any thresholds of increased taxation, it may be advantageous to sell some shares that have seen tremendous gains in order to lower your potential future tax burden. This is similar to tax gain harvesting except you use the proceeds to live rather than to buy shares of a similar fund.

You can also decide when to sell shares. If you know you’ll need money in the winter, you get to decide not only how much of a tax impact your withdrawal will have, but whether or not it will occur in the current tax year (December) or the next one (January).

When you receive a dividend, you have no control over the size of the dividend or the timing of receiving it, and 100% of the money you receive will be considered income, whereas when you sell shares, only the difference in cost from your purchase price may be subject to taxes.

To better illustrate this concept, I’ll contrast selling shares that have seen various returns with receiving a dividend. You’ll see the same amount of money land in your bank account in all cases, but only the portion in red will be subject to taxes. When receiving a dividend, the whole enchilada will be subject to taxes.*

 

Dividend Tax

 

If you find yourself in the 25% federal income tax bracket and live in a state with an average sized state income tax of 5%, you can expect to pay 20% in taxes on dividends and long term capital gains. In this scenario, how much tax will you pay to access $10,000?

  • If it comes all in the form of dividends, $2,000
  • If you sell shares that have quadrupled? $1,500
  • If you sell shares that have doubled ? $1,000
  • If you sell shares that have appreciated 10%? $181
  • If you sell shares with no gain? $0
  • If you’re stuck selling for a loss, you can earn a tax deduction when you collect the money from that sale.

 

*Of course, it is possible to keep income low enough to avoid taxes on dividends and long-term capital gains. Live in a state with no income tax and you may avoid taxes on dividends entirely. But numerous income streams can foil those plans, sending your taxable income north of the magic number of about $75,000 for couples (half that for singles) including Social Security Income, withdrawals from tax deferred accounts, unanticipated blog income, and yes, dividends themselves. The tax code could also change, and the tax-free dividends in the 10% and 15% federal income tax brackets could disappear.

Are you curious to know my blog income? Sign up for my e-mails and you’ll receive my next quarterly update in about a week. I only share revenue data in my quarterly newsletter for subscribers.

Should One Avoid Dividends at all Costs?

 

Dividends are not going to sink your portfolio, they’re simply suboptimal in a taxable investing account, and we want to do all we can to optimize. In my portfolio, I see a tax drag of about 0.6% of the portfolio annually with taxes on dividends of about 30% on a 2% dividend.

How could I improve this? I could continue to invest more in Berkshire Hathaway and other companies that have not been paying dividends. I could sell what I’ve got and start from scratch, but that would come with disastrous tax consequences, so there’s no way I’m actually entertaining such an idea.

What’s an investor to do? For one, don’t focus on dividend paying stocks or funds in a taxable account. If you have no interest in tax loss harvesting, consider tax managed funds. If you’re really keen on avoiding dividends and willing to forego some diversification, load up on BRK.B and other no-dividend payers in taxable. If you chooose to slice and dice, keep your higher dividend stocks and funds tucked away in a tax advantaged account.

Recognize that avoiding dividends does come at a cost, even in your taxable account. In 2016 alone, I was able to take $46,000 in paper losses by tax loss harvesting (TLH). That’s good for a $1,300 to $1,400 per year tax break for the next 15 years in my current tax bracket. It’s easy to TLH with standard index funds, not so much with tax managed funds, although it wouldn’t hurt to exchange into one knowing that you may eventually exchange out of it.

 

What’s Worse Than Focusing on Dividends?

 

Owning a dividend focused portfolio in a taxable account is less than ideal, but there are many far more agregious sins in the investing world. For example, you could:

  • Own actively managed funds in taxable that create far more taxable events due to high turnover.
  • Invest haphazardly with no defined plan or goals. Buy high; sell low.
  • Keep all of your savings in a savings account, slowly losing buying power to inflation.
  • Fail to save enough money to have anything left over to invest.
  • Buy loaded funds. You’re automatically down about 5% the first day.
  • Trust your money to someone else without knowing or understanding how it’s invested.

 


You’re still not using Personal Capital? Track all your accounts in one place like I do.


 

I’ve learned that dividend investors treasure their dividend paying stocks and funds and to some, suggesting dividends are anything but awesome is akin to kicking their dogs or talking trash about their grandmothers. The dialog can quickly become emotionally charged.

The truth is, if you are savvy enough to consider the pros and cons of dividends in your portfolio, you are likely in a position to excel no matter how you choose to invest. The 0.5% you might come out ahead or behind won’t be the difference between boating in a dinghy or a 54-foot yacht.

Nevertheless, I want to help you get the most bang for your invested buck. For the high income professional, understand that a high dividend strategy can work against you.

 

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75 comments

  • Dr. POF, You are going to take some flak for this from the DGI lovers! Lucky for you (and for me), I am ambivalent to both dividend stocks and index funds, choosing to be opportunistic over the choice based on personal situation. For those interested, I have written an investing series on this topic comparing the two investment strategies, which you may know.

    I think your strategy is a sensible one, considering taxation. For those in higher income tax brackets throughout life, with likelihood of remaining in relatively high marginal tax brackets in retirement due to higher passive income/expense withdrawals, it make sense to focus on total returns in taxable accounts and optimizing withdrawals to actual needs rather than to have massive dividend inflows, a sizable part of it may be reinvested anyway. Sensible post, doc!

    • I expect to take some flak, but I tried to be fair and dispassionate in my explanation.

      Many docs will be investing in a taxable account for 2 to 4 decades. There’s no sense in seeing your returns eroded unnecessarily due to higher than average dividends. I’ve been investing in taxable for 8 years now and more than half of my retirement savings is now in taxable.

      Best,
      -PoF

      • If their timeline is 20-40 years, DGI is sub-optimal! The purpose of dividends is to generate cash flow. If you don’t want that, you’d rather the company reinvest that into the business and increase the ROE, rather than pay out a (relatively) favorably taxed dividend. You don’t want cash now, so why invest in something that gives you that – you’re doing docs a service!

          • “Let me explain why you I much prefer the latter, assuming the total return of the two options is equal.”

            This is where your model breaks down in reality.

          • Yes, he is, but when you’re worth $80 Million, a few thousand dollars in taxes don’t concern you in the least. That’s what we’re talking about today. Optimizing.

            Another Bogle quote on dividends:

            “If you really need the dividend income, I see nothing wrong with overweighting high-dividend stocks, knowing you’re taking a small risk of falling significantly behind the total market.

            But you can own blue chip stocks, and you’re going to get a higher dividend, a situation I think would be attractive to an awful lot of investors. But once you depart from the market portfolio, you’re taking on extra risk.”

            Source: http://www.etf.com/publications/journalofindexes/joi-articles/24198-legends-of-indexing-john-bogle.html?nopaging=1

          • I agree with you to put investments in tax deferred accounts. But you should not let the tax tail wag the investing dog and dispose of everything you own just because it pays a dividend ( for the same reason you stated that only owning blue chips could be risky).

            On a side note, your article looks like a take down on dividend investing/dividend bashing. And I find it surprising that you were calling me out on it. I am not sure why Dividend stocks are attracting a lot of hatred by the so called FI community, the same way FI community attracts hatred from mainstream media comments. Ironically, the newer the blogger ( like your lawyer friend), the more the dislike dividends. I don’t get it.

            The funny thing is that the dividend aristocrats that I invested in, have kicked the butts of index funds you own over the past 10 – 20 years…

            How would you have done if you had invested in dividend aristocrats when you started investing, over your index fund selections? I would love to read this article..

            When questioned about my choices, I look at it from the perspective of two alternate universes.

            One where I invested most of my money in dividend stocks (dividend aristocrats) over the past decade and a second one where I invested most of my money in index funds.

            Those dividend aristocrats have done much better over the past 10 – 20 years than what my index fund selections would have been.

            So I am happy with my investments. Good luck and take care!

          • Btw Bogle is talking about the average investor focusing on dividend income, and forgetting about stock prices. Not about himself.

  • GYM

    I used to be a dividend lover fanatic but now I’m more of a balanced approach kind of girl. I have mainly index funds now. Interesting to read how dividends are taxed in the US. In Canada there is actually preferential tax treatment for owning shares of Canadian dividend paying companies. So much so that one could have $40-50k of income with dividend payments only (eg no other income) and not pay income tax.

    I do miss the higher yield you get from owning dividend paying stocks rather than ETF, so that’s why I have both in my portfolio still 😉

    • Thanks for the comment, GYM.

      We actually have that favorable tax treatment, too, and the dividends can come from any source, not just domestic companies. The problem, particularly for the high income professional, is that income may never be low enough to qualify. It won’t happen during the working years, and if a significant portion of their retirement savings is tax deferred, income may be too high in retirement also.

      Cheers!
      -PoF

      • To what extend do you believe selling and receiving a dividend is the same, because your judgment is clouded by the fact that we are in the midst of a 9 year bull market? I see that as an example for the recency bias.

        The bogleheads from 2008 knew that dividends and selling were NOT the same thing:

        https://www.bogleheads.org/forum/viewtopic.php?f=10&t=30085

        On a side note, I was shocked that lead boglehead Taylor Larimore was considering selling his equities and moving to bonds AFTER stock prices had collapsed in 2008.

        • That’s not what he was saying. It was not well worded, as he admitted in the thread with this apology. He was actually paraphrasing Bogle.

          From Taylor Larimore:
          “I was not clear. Forget my figures which I (incorrectly) thought would help.

          All I was trying to say is:

          We should not invest in stocks if we cannot afford to lose (especially in retirement).

          I’m trying to say what Mr. Bogle said in the above post made while I was preparing mine. ”

          The Bogle quote:

          “The probabilities for stock market investing right now are very compelling,” Mr. Bogle said in a telephone interview from his office at the Bogle Financial Markets Research Center, on the Vanguard campus in Malvern, Pa. The cataclysm in world financial markets has brought down valuations to fairly attractive levels, he said, improving the prospects that the broad stock market, over the next decade, can earn an annualized return of perhaps 9 percent.

          So this isn’t the time to sell, he said, but he allows one big exception: “If you cannot afford to lose another penny, then you simply have no recourse but to get out of the stock market.”

          Stocks could easily fall further, and if you aren’t in a position to absorb more losses, you must protect yourself. And retirees should hold a big dollop of bonds, which generate income and provide ballast in a shaky market. “Investing isn’t just about probabilities,” he said. “It’s about consequences, and you’ve got to be prepared for them”

  • I’m going to bookmark this one for when I’m ready to come back and concentrate on all the goodness here.

    My plan is to go all in on VTSAX once I start funding my “15 year gap fund” starting late next year. Maybe I need to dig a little deeper… But, at least I know I’m avoiding a dividend trap, so to speak. Nice post, Doc!

  • Apart from tax-managed funds (which, as you say, have fees which may cancel the benefit), there don’t seem to be a good option here, methinks. I’m a big proponent of the simple, 3- or 4- fund portfolio, which means my taxable account consists entirely of Vanguard’s Total Stock Market and Total International Stock Market—with the corresponding dividends. It looks like I’m stuck with them.

    My best hope would seem to stay inside that magical 0% LTCG bracket by selling my shares with the least appreciation in early retirement, and hoping my dividends don’t bump me up too high. Even if I do creep into the 15% LTCG brackets, it still won’t break the bank tax-wise.

    Thanks, PoF!

    • I would tend to agree, Dr. C. If you want to keep it simple and well diversified, you’ve got to live with some dividend income.

      There are not-so-simple ways to have exposure to the S&P 500 without dividends, but they involve futures or options. You could also opt for a “basket of stocks” but rebalancing and loss harvesting becomes complicated very quickly.

      Best,
      -PoF

      • I am with Dr. Curious on this one. I always thought of dividend funds as something for my retirement age, when I need cash flow and a lower tax bracket. All of that will depend on 1) If I stick it out for a pension at my current job and 2) how much money I have saved. It will be interesting to see what happens going forward.

        Great review and thanks for sharing…doesn’t change what I do today but good to put the idea back in my mind.

  • Jon

    POF, great post, as usual — well-written, relevant, educational. I invest in our taxable joint account (3 index funds) every 4 or 2 weeks depending on the time of year. I have never kept track of specific lots. Is there a reasonable way to reverse engineer this data or can Vanguard provide this for me…or do I just start keeping track going forward, a la the spreadsheet you shared in your recent Lakefront post?

    • Good question, Jon.

      Brokerages have been required to keep track for you since 2011. I suspect many were doing it prior to the mandate. To see the costs and gains of particular lots, log into your account, click on “Cost basis” above your taxable account, then”View/Change cost basis method, and select “Specific Identification (SpecID)” for each fund in the dropdown box.

      It may take a day or two for the correct information to populate.

      Best,
      -PoF

  • hatton1

    Another well thought out post. I think dividends are just plain hard to avoid if you amass a large enough portfolio. In looking at my Vanguard data I received $110000 in Dividends and LTCG in 2016. I have a couple of active funds that have too large of gains and poor records to ever sell so I get large LTCG from them every December. I have never tried to avoid dividends or to deliberately increase them. I simply realized they will pay for my retirement needs. If you index you will have dividends and if you save enough money they will be a significant source of income. I do not ever anticipate being in the 0% bracket for dividends. First world problem.

    • You probably saw this one coming, but those active funds (or portions of them) would be perfect for starting up or contributing to a Donor Advised Fund. I had some T. Rowe Price active funds that were horribly tax inefficient, and I started my first of 3 DAFs with them.

      Of course, I agree that once your dividends alone put you past the 15% tax bracket, taxes are unavoidable unless you become a big spender and / or philanthropist.

      Cheers!
      -PoF

  • Funny enough, I got into dividends because it helped me scratch a stock picking itch.

    It helped that I did most of the investing during the Great Recession, so now I look like a genius (I am not, just opportunistic)… but would I have been a bigger genius investing in non-dividend producing companies?

    Probably – but now the cash flow is great for someone with irregular income.

    It’s nice to know that dividends cover a great majority of our fixed costs and I can reinvest the profits of my business back into the business.

    But maaaaan taxes are not fun. 🙂

    • Jim, You were smart to be like Warren — Greedy when others are Fearful.

      As an aside, I’m waiting to see what the proposed tax plan will have to say about tax-free qualified dividends and LT capital gains. Will they persist? At what bracket? 12% 25%?

      I suppose none of it matters if nothing gets passed, but it that deal goes away, it will mean tax headaches for early retirees regardless of dividend strategy.

      Best,
      -PoF

  • Uh oh – looking to start a riot! Luckily Meb Faber has been spreading the good word as well, so you aren’t alone.

  • Thanks, POF. I had to read this post a few times, but I’m glad that my strategy for my taxable account aligns with what you described in this post. I currently have my taxable account split 50-50 between VWITX (Vanguard Intermediate-Term Tax-Exempt Fund) and BRK B. Now, I need to go back and read your tax loss harvesting post… 🙂

    • Wow – that’s a seriously tax optimized taxable portfolio. It’s too bad we don’t live in a state with a Vanguard muni bond fund so you could avoid state tax on the bonds, too.

      I need to write a more thorough TLH post. The only one I have is the Brexit post. I’ve been waiting for a good opportunity and none has come along in awhile. Not that I’m complaining.

      Cheers!
      -PoF

  • This is one of the few – and practical – approaches I’ve seen explaining dividends and taxation (which is what a lot of folks forget to think about). Jim is correct in that folks use dividends for cash flow. I haven’t dived deep into them just yet, but maybe worth looking into when I start to focus less on growth. Thanks!

  • While I don’t actively avoid dividends I also don’t personally them. Part of it is the tax drag you mentioned but part of it is I’m no good at stock picking. The presence of dividends in it’s own is a poor indicator of future performance. Ie it could just be lipstick on a pig or it could be.the real deal. I don’t trust my ability to choose a winning dividend stock any more then a long term value stock. If I can’t trust either just don’t do it. Buying a mutual fund of dividends has higher fees then the index funds I largely stay with.

    • Some data, and I emphasize some, does show increased returns for dividend growth stocks, but who’s to say that will persist? And are you simply being compensated for increased risk?

      I also wonder if the fascination with these dividend darlings has helped drive the price up. If it’s a truly efficient market, the answer should be No, but the popular kids don’t necessarily stay that way forever.

      Cheers!
      -PoF

  • This is the reason that I am skeptical of dividend investing as a strategy. The idea of having a cash flow sounds great, but when you stop and think about the tax inefficiencies (particularly in the accumulation phase) it starts to seem less promising.

    • You’ve identified a key point, Matt. It’s the accumulation phase where dividends are a real drag. Most early retirees will find themselves in a tax bracket (15% or less) where qualified dividends and LT capital gains are tax-free. But while working? It’s a different story.

      Cheers!
      -PoF

  • Completely agree! Someone should come up with an ETF product: Split the S&P500 into two equal parts: 1) low/no-dividend stocks and 2) high-dividend stocks. Then hold ETF-1 in the taxable account and ETF-2 in a tax-advantaged account.
    Actually, if your portfolio is large enough, you might just construct it yourself. Maybe not with the S&P500 but certainly with the 100 largest stocks in the S&P, sorted by dividend yield, where you keep the higher-yielding stocks in the tax-deferred portfolio. It would also create more opportunities for tax loss harvesting!

  • Nice topic. I always thought of dividends as part of the fundamental return of stocks, the other part being cap appreciation as you mentioned. This is the line that Bogle and Prof Jeremy Siegel (among others) seem to take, so I’ll buy it. So, I always looked on those dividends as part of the return, and when they land in my account every quarter, they feel good. I think its more complicated. Dividends seem to go back to a time when only very wealthy bought stock and lived off the dividend, never touching the principal. I think the tax code was different back then. I know I’m oversimplifying.

    However, I am reminding myself more that $1 dividend paid is $1 stock price loss. That is how dividends work. So, like you say, I would rather not have the dividend, instead having it rolled into the stock price (like Berkshire) and allow me to sell and take the gain when I want, thereby delaying taxes. I don’t need the dividend now for living expenses because I am working full time and am in my highest earning years and therefore tax bracket. (A tax delayed is a tax not paid?)

  • HospitalDoc

    PoF,
    How about in times of recession where you have to sell at a lower price? You don’t know how long the recession will last.

    If you have an index fund with good dividend yield in your taxable account, that will be a good security that you don’t have to sell a stock in a lower price and lock in your losses.

    Thank you for a great post as always!

    • Thanks for the question, HospitalDoc.

      Receiving a dividend when the stock is down has the same effect as selling an equivalent number of shares. The difference is with the dividend, you are functionally forced to sell. You get some money, and the value of your investment in the dividend paying stock / fund drops accordingly.

      What you can do is have a cash or bond (my plan) cushion and use that in the case of a bear market. Real estate can play a role here, too. You can leave your stocks alone or buy more if you’re still workng for a living.

      Best,
      -PoF

      • HospitalDoc

        Thanks!!!

      • CM

        “Receiving a dividend when the stock is down has the same effect as selling an equivalent number of shares. ”

        Not exactly, unless you believe that stocks are never undervalued or overvalued (i.e., you disagree with Warren Buffett).

        I would much prefer to sell shares of EMC in 1999 (to fund my expenses), rather than receive a dividend, because the shares (like most tech shares) were grossly overvalued.

        On the other hand, I would have preferred to receive dividends from the typical thrift, REIT, or small-cap value stock in 1999, because most of these shares were undervalued. Selling those shares for cash then would have been like selling the family jewels at a pawn shop; you’d receive a very low percentage of the actual value.

        This was evident in real-time–not just for me, but for any value investor worth the name.

        Note: I’m not a “dividend investor.”

        • I can’t argue with that logic, nor would I want to. Of course, the right call in that case would have been to sell all shares EMC and put every penny into the REIT or small cap value fund.

          But when looking at one investment in a taxable account, selling shares of it is treated more favorably from a tax standpoint when compared to receiving a dividend from it. That’s the point I’m trying to make today.

          Best,
          -PoF

  • I basically agree. I do have some ambivalence about dividends. I have some private investments that pay big dividends. I’m not crazy about the tax effect, but I don’t want to turn down the 120K or so per year in income that spins off.

  • Luis

    Even if you have a taxable account that’s tax efficient:only municipal bonds,etf,index fund,tax managed fund,etc still you’ll have income/dividend available,this will prove very valuable in a situation of down market(bad sequence of return) since this influx is remarkable stable regardless of market conditions and you don’t have to sell stocks fund to fill at least part of your necessities of money.A completely different story is the investor that is value oriented:by definition his/her portfolio is not well diversified.

    • Thanks for the comment, Luis. I agree on the value only focus. There’s no need to take uncompensated risk by ignoring half the market.

      Regarding the dividends, I don’t know that the income is as stable as you would want it to be, particularly from stocks or stock funds. The dividend aristocrats of the 1990s did not fare so well. https://seekingalpha.com/article/3901726-fate-49-dividend-aristocrats-early-1990s-may-give-nightmares

      Best,
      -PoF

      • Luis

        Something is lost in translation:let’s see an example,you have one million $ total stock market,in a taxable account,retire this year and need 30 k to supplement other forms of income(ss,part time job,reserve fund,etc);then the stock market plummeted 50%:do you sell stock mutual shares or you redirect the income and dividend to use for daily expenses?In the later you don’t have to sell your shares.TSM had paid consistently around 2% in dividend in the last year,even during 2008 stock market crash,that’s my point.May be don’t get the 30k,but close to it.

        • Consider 3 different scenarios in a taxable account. Assume you have a mix of stocks and bonds in a 401(k), IRA or Roth, too. For the taxable account:

          1. You have a million in a dividend portfolio paying $30,000 in dividends per year (3%).
          2. You have a million in VTSAX paying $20,000 in dividends per year (2%).
          3. You have a million in BRK.B paying no dividends.

          The value of your portfolio drops overnight. In each scenario, you now have $500,000 in the taxable account and need to come up with $30,000. Assume the market remains flat that year after the big drop.

          1. $30,000 in dividends are paid. You have $470,000 worth of dividend stocks left and your needs are covered. your taxable portfolio is worth 6% less.
          2. $10,000 in dividends are paid. You have $490,000 worth of VTSAX left and you need to come up with an additional $20,000. Your taxable portfolio is worth 2% less.
          3. You still have $500,000 worth of Berkshire stock and need to come up with the $30,000.

          In options 2 and 3, you have depleted your portfolio less or not at all. You can choose whether or not you want to sell low to cover that $30,000. You might have it in your emergency fund or cash cushion. If not, you could sell stock from taxable, but exchange from a bond fund into VTSAX or BRK.B in a tax advantaged account to effectively spend down the bonds without changing your stock position.

          You would also have the option of earning income to cover that $20,000 or $30,000 shortfall. I much prefer options 2 and 3 to option 1.

          Best,
          -PoF

          • Jj

            You are wrong in 1. Dividend does not reduce stock value.

          • That’s exactly what happens with mutual funds and essentially what happens with stocks. The exact amount of the dividend may get lost in intraday swings, but the value of the stock typically drops by the amount of the dividend.

            From Investopedia:

            “Price Implications

            When a dividend is paid, several things can happen. The first of these is changes to the price of the security and various items tied to it. On the ex-dividend date, the stock price is adjusted downward by the amount of the dividend by the exchange on which the stock trades. For most dividends this is usually not observed amidst the up and down movements of a normal day’s trading. It becomes easily apparent, however, on the ex-dividend dates for larger dividends, such as the $3 payment made by Microsoft in the fall of 2004, which caused shares to fall from $29.97 to $27.34.

            The reason for the adjustment is that the amount paid out in dividends no longer belongs to the company and this is reflected by a reduction in the company’s market cap. Instead, it belongs to the individual shareholders. For those purchasing shares after the ex-dividend date, they no longer have a claim to the dividend, so the exchange adjusts the price downward to reflect this fact.”

          • jj

            The exact amount of the dividend may get lost in intraday swings, but the value of the stock typically drops by the amount of the dividend

            .

            wrong again.
            Dividend is declared per share before paying out by company–no such thing like “get lost in intraday swings”. Stock price has intraday swings and but it’s ultimately determined by supply and demand.

            there are companies paying quarterly dividends for over 100+ years. so according to your Investopedia, those companies’ stock prices should be zero or deep in red?

            • Of course not. That’s just one source, but there are many others that will tell you the same thing with varying verbiage. It’s not my Investopedia. It’s one of many sites created to educate you and me.

              Stock rises 3% in value, kicks out a 1% dividend. The value is up 2%. Happens quarter after quarter.

              Some stocks have dropped to zero, but that’s the exception to the rule. It’s perfectly possible and normal for a company to increase in net asset value while kicking out dividends on a regular basis.

          • jj

            If you are not a trader, why those price swings concern you?
            If you are not selling, why concern your portfolio value, or instant price reduction after kicking out dividend? Non-dividend stocks have huge price swings as well. so if you want to take out 30K from your 1., then you need to take out the same from your 2. and 3. as well.
            during market crash, you can see your stock value down 50%+ (not because of dividend payout) but dividend keep the same or even increasing.
            do you aware of a lot of people keep dividend stocks from grandparents and get yearly dividends more than what they paid for?
            Please look at the Dividend Aristocrats–not possibility but facts.
            Those “education” places can be very misleading or not let you to see the big picture.

            • The difference is in the taxation of the three. That’s it. Portfolio value will be otherwise identical, but you take the bigger tax hit in the dividend portfolio. This, of course, only applies to a taxable account.

              An increasing dividend in a stock or fund that has lost half its value is nothing to celebrate. That’s just a much larger percentage of your portfolio value granted to you as a dividend. If you’re taking the dividend out of the portfolio instead of re-investing, you’re still depleting the value of the portfolio, but in a tax-inefficient manner.

              I am well aware of the dividend aristocrats.

              Please read this article from a well respected author for another perspective.

              Best,
              -PoF

              • Jj

                I read all. When I found out from the numbers out from my own portfolio and prepared my own taxes, I never look back.
                I ‘d suggest you study more, not from theory but real one then you come back to me. It’s for your own good. I know for the fact what you said is wrong.

          • jj

            I referred your article to my friends who have over 20+years of investing having such comments:
            —“a lot of assumptions…”
            —” The writer of the article is comparing apples to oranges and only talking about an after tax account. He’s basically saying if you are in a 20% tax bracket and receive $10K in dividends you pay $2K in taxes. Then he goes on to say if you sell $10K in shares that doubled in value to get the same $10K, you would pay only $1K in taxes. But, that means that $5K of the amount came from the basis cost (principal) and 5K came from capital gains. So, he is still paying the same tax rate, except in the second example he’s eroding his principal. The logic is flawed.”
            I normally ignore such article because you aren’t professional on investing but trying to mimic WCI for sideline incomes. That’s fine but you need to be careful of what your write. I have kid who’s physician I don’t want her to be mislead.

            • jj,

              I am not trying to mimic WCI. In fact, The White Coat Investor, Dr. Jim Dahle, has partial ownership in this site. He loved what I was doing here, the quality of the articles, and the fact that my site is not a poor facsimile of his own.

              This article is being discussed on this thread at The Bogleheads site, which has tens of thousands of people who have been investing for decades. I strongly encourage you to see the response and critiques there before you sling any more mud.

              Your friend’s explanation starts out strong. Yes, it is the same tax rate. Regarding eroding principle, it’s the same end result in each of the present scenarios in terms of final portfolio value until you figure in taxes. That’s the point. You can control your taxes better by selling shares as opposed to taking the dividend the company chooses to give you.

              I don’t want your son or daughter to be misled, either, which is why I write articles like this exposing the potential danger of blindly investing for dividends in a taxable account without considering the deleterious effects of taxation.

              Best,
              -PoF

  • John

    If you are pulling out under 80 – 100k after retiring you could set it up to have it come out almost tax free, however if you can grow your account large enough you won’t be able to do that. Just like the larger your taxable account is the less flexibility you have with selling or trading stocks due to the tax consequences. Unavoidable to have taxes on 340k in dividends a year.

    I also use options for stock accumulation and income as well which is very aggressive and not for the masses. Granted I’ve averaged a 42% return each year for the last 6 years. About 600+% Cummulative in my aggressive stock account. My conservative runs at about 14% for the last 10 years.

    • Yep — first world problems for sure. But with index funds, or even the dividend growth ETF NOBL, you could have a taxable account of up to $5 Million (with current yields) before you see $100,000 in dividends.

      Those returns are outstanding. My understanding is that options are essentially a zero sum game, right? Your gains come at a less experienced (or unlucky) investor. I wouldn’t want to enter that market without a much better understanding of what I’m getting myself into.

      Best,
      -PoF

  • Thank you for this! I’d come to a similar conclusion (with the tax implications) on my own, but with sooo many people talking about dividends paying off I thought maybe I was crazy.

    Out of curiosity – do you hold any bonds in your taxable account? For states without a muni bond fund, I’d be curious what conclusion you came to on that. I ended up going with Vanguards Intermediate-Term Tax-Exempt fund – which has about the same yield as the total market bond fund, but due to lower turnover (61% turnover for total bond, 9% turnover for the Intermediate-Term fund) the dividends are qualified at least.

    • Judging by most of the comments, Adam, I’d say we’re not alone in our thinking.

      I’ve contemplated bonds in taxable, but haven’t done so yet. I live in a high-tax state with no Vanguard bond fund. In MN, my marginal state tax rate is 9.85%. So I keep bonds in my 401(k) and HSA for now. WCI has written a controversial post stating that “bonds go in taxable.” Check it out.

      Best,
      -PoF

  • Skippio sextus maximus royale

    Super phaat article. I’ve been struggling between the passive income through dividend camp and the dividends in taxable are for fools camp. The struggle is real man, but I see the light.

  • EnjoyIt

    I used to be a dividend growth investor until I became a physician and had all those dividends taxed at 23.8% federal income tax. I have since switched over to index funds but still have a few highly appreciated dividend paying stocks that I won’t sell for tax purposes. You can really feel the tax drag on those paying twice the taxes as compared to an equal value of total stock market index fund.

    Today 62% of my portfolio is in taxable which means that I would have to pay significant taxes on dividends. I keep Vanguard intermediate term tax exempt in my taxable account as well as my international, and filling out the rest is total stock market with a few of those legacy dividend stocks. This is about as tax efficient as I can get myself outside of owning Berkshire instead of total stock market.

    Would I have higher post tax total returns sticking with those dividend paying stocks? I don’t know. I can’t control how those stocks perform, but I do have some control over how I am taxed.

  • This is a great topic. I find it interesting that people focus on dividend paying stocks that pay 1-2% dividend when you can get REITs that pay a consistent 9-11% dividend and have done so over years and years with relatively stable stock prices.

    With that said, I’ve been at many, many stock trading seminars where I’ve spoken to people who have managed millions of dollars and it never occurred to them to just sell the gain out of a holding and pay 2-4% taxes on the gain, rather than 30-50% taxes. It’s such an easy way to save tons of money, exactly as you said. Once you take the emotion out of investing and turn it into a math problem, imo it becomes much easier to be successful.

    Great article, thanks for posting it.

  • I completely agree with the importance of minimizing dividends in a taxable account during the accumulation phase if you are in a high tax bracket.

    However, there is something psychologically (not logically) satisfying about being able to live completely off dividends in retirement.

    For this reason, when I am in a very low tax bracket in retirement, I have considered transferring my taxable account stock funds (currently in Vanguard Total Stock Market and Total International) to the Vanguard High Dividend yield index fund. This fund has a yield close to 3%, which, incidentally, is the safe withdrawal rate that I am targeting. Of course, the transfer of funds would be a taxable event, and I would lose international diversification with this approach.

    Another option would be to amass a portfolio 50x living expenses, and then live off the ~2% dividends from my current taxable allocation (Vanguard Total Stock, Total International, Intermediate Tax exempt).

    Finally, I could simply come to grips with the fact that selling shares is no different than receiving dividends. In this case, I would use a combination of collecting dividends and selling shares to produce the desired 3% withdrawal rate.

    At any rate, thanks for getting us all thinking about this!

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  • Grant

    Very nice summary of the issue, PoF! It’s true that if you only have dividend payers you will have a less diversified portfolio which therefore will have a wider range of outcomes which on average will be less than the market portfolio. So not optimal. In other words, more risk with no increased expected return. It’s fascinating that some investors, like Dividend Growth Investor, just love getting dividends for various behavioural reasons, and no amount of data can convince them that that is not the best shot at getting you the optimal outcome. A good review of the subject here.

    http://www.etf.com/sections/index-investor-corner/swedroe-irrelevance-dividends?nopaging=1

  • Gasem

    I don’t hold any dividend payers in taxable accounts. If you have some LTCL and a tax efficient stock portfolio you hold what I call a “rich man’s Roth”. Just sell some shares pair it with some LTLC and pay 0$ tax. Dividends just mean you have to pay taxes and rebalance more often. In my opinion determining how a given stock changes a portfolio’s performance and diversity determines it’s utility in a portfolio.

    I did some paper trading over the weekend in several google finance portfolios, using the Harry Browne Permanent Portfolio. I compared against several common portfolios like 60/40 and 3 ETF’s.

    Harry Browne’s portfolio is known for its steady return and low volatility in about any market condition. I started with $100K in 2007 split equally between VTI, BIL, EDV, and GLD. I then added $100K each year split equally on Jan 5 of the year to the mix. The result was a portfolio that made money every year except one during the “worst recession since the great depression” (i.e. very low volatility), and the year it lost money it was down only 4%. The loss that year was due to a crash in GLD, but GLD was responsible for it’s stability for about 6 of those 10 years. It’s 10 year return was about 4%/yr over inflation.

    I was working on this because I’m thinking about writing an article about tuning diversity in a portfolio using google finance. I made a small change in the mix and instead of investing $25K each year in VTI, I invested $23K and put the other $2K in BRK.B as a single issue diversifier. Over the course of the same 10 years that portfolio returned 12.9% per year and was never under water, but there was more than adequate chance for tax loss harvesting during the course of those years since while some assets were way up others were way down. I feel I better spend my time tweaking portfolio diversity than worrying about dividends. None the less I’m a hawk on tax efficiency.

    My own portfolio holds about 16% of these “single issue diversifiers” which are all tax efficient and each issue does something specific for the portfolio’s diversity and performance, like adds momentum and lowers volatility.

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  • Ally

    Great article, as consumers of financial information on the interwebs, the challenge is adopting a big picture view. Instead, more often than not, you encounter camps – the real estate camp, the dividend investing camp, the index fund investing camp. Most just talk about how great their strategy is without comparing to others or combinations of several. But to quote White Coat, money is fungible, so you have to figure out the best place for your money. I’ve even encouraged a financial blogger or two (looking at you Jim W. :)) to compare a couple of strategies head to head to see which one comes out ahead with a finite amount of money invested (which is the case for most of us). No one has done so yet, but this article is a step in the right direction. In my opinion, there is a time and a place for dividend investing – I think people near or in retirement should definitely utilize dividend kings, aristocrats, and such. They’re not in the position to gamble that this long bull run will continue much longer considering their active earning years are done. In their case, getting a stable 3% on a few blue chips is a nice alternative. For rest of us younger folk (or just me specifically), i’d much rather get 6% on a rental property vs. 3% on a high yield dividend stock or ETF or take further market risk. But bottom line – every situation is different.

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