6 Problems with Dividends for Income

December 1, 2013 — 3 Comments

If you own a company with a $1 share price, and it pays a 5c per share dividend, you get 5% in investment income.  While this is a natural solution for retirement income, it has problems.  Some of them stem from the way dividends work:  The share value goes down to 95c (reflecting the cash that the company paid out and no longer has) + you get 5c in cash, leaving you with an unchanged total of $1.  That is, until tax time.  You have to pay taxes on the 5c, reducing the value of your investments.  Below is a list of problems, created by this effect among other factors:

  1. Amount:  More dividends than needed result in unnecessary taxes.
  2. Timing:  The dividend is in cash, not invested, until using the money (called “cash drag”).
  3. Irregularity:  Dividends can be increased or decreased unpredictably – too much creates cash drag & too little creates income stress.
  4. Tax Loss:  If your stock is down, you use dividends for income instead of selling losing shares for income.  Selling losing shares can provide a reduction in taxes.
  5. Limited Growth:  Companies tend to pay dividends when they have limited growth prospects (e.g. utility companies).  Some of the fastest growing companies pay no dividends.
  6. Rebalancing:  By using the dividends for income, you miss out on selling from the biggest gainers in your portfolio to rebalance while generating cash.

Selling from stock investments is far superior:  you can sell from your fast-growing companies, the exact amount needed, when needed, combined with rebalancing & tax-loss harvesting.

Advisors often avoid this optimal solution, since it requires more work and careful planning.  Specifically, it requires setting dividends to reinvest, while carefully planning when to sell to avoid wash sales (i.e. selling at a loss within 30-days of the automatic dividend reinvestment).

Disclosures Including Backtested Performance Data

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Gil Hanoch

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3 responses to 6 Problems with Dividends for Income

  1. Thank you for your article!
    There’s something I don’t get: If you have enough retirement money to live on, why not just purchase non-dividend stocks for funds, hold them for at least a year, and pay no (or lower) capital gains tax? Why am I not seeing this advice all over the Internet?
    Art

  2. Art, you are correct: Holding everything else equal, I would prefer non-dividend stocks. What you described make sense. And if you don’t really need your investments for income, you can hold the money for many years, giving you compounded growth before paying the taxes. And, if you don’t need the money in your lifetime, you get a step-up in basis when you die, and your heirs get the money completely free of investment taxes.

    I wouldn’t avoid dividend paying stocks. If I were a stock picker, I would simply compare them to other stocks while giving a slight discount due to the tax disadvantage.

    I believe that the intuition of dividends for income is very strong. It is convenient to be told “this is your principal and this (dividends) is your income”. And people have a misconception that they count on dividends and the principal will be protected forever, ignoring the risk of any company going bankrupt. This is my theory for why it is not all over the Internet. I conduct unbiased research, and came up with a number of conclusions that contradict conventional wisdom.

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