Many investors don't pay attention to the impact of dividends on their investment performance. This is understandable - headlines tend to focus on price swings of stocks rather than their dividends (and some stocks don’t even pay dividends).
Despite the lack of focus on dividends, they significantly impact the wealth of most investors (for better or worse). For example, more than 75% of the stocks in the S&P 500 have paid dividends over the past year, and those that did yielded 2% in dividends on average. If you’re invested in the stock market, you may be receiving more dividends than you realize. This means you should monitor how your dividends are taxed.
Tax Rates - Higher Than You May Realize
Dividends for a typical U.S. investor are taxed in one of two ways when they are received. Investors receive “preferential” taxation on dividends if they meet certain “qualified dividend” criteria, such as holding period requirements. For high-earning individuals in high-tax states, this “preferential” all-in tax rate can be upwards of 36%. Many investors are often surprised to learn that the “preferential" tax treatment for dividends is as high as 36%.
Alternatively, dividends that fail to meet “qualified dividend” status can be taxed as ordinary income, which means the all-in tax rate can potentially shoot up above 50%. However, if your investment manager is investing in traditional U.S. stocks and not overtrading, then most of your dividends will likely meet qualified dividend status at the “preferential” rate of 36%.
The crucial caveat to dividend taxation rates is that there are zero taxes on dividends upon receipt into qualified retirement accounts (such as 401(k)s and IRAs). The vast majority of investors fail to take advantage of this simple benefit (even if they fully fund their retirement accounts each year). Read the following illustration to learn how this simple provision creates a missed opportunity for many investors.
Illustration of Dividend Taxation
Let’s illustrate how taxes on dividends for many high-income individuals are higher than they need to be. We first consider a typical high-income investor as a base case and then explore a more thoughtful approach.
Many investors employ the same investment selections in both their retirement and non-retirement accounts. For example, if an investor chooses to invest in the S&P 500, they may choose to hold that investment in both their 401(k) and their taxable brokerage account. How does this impact dividend taxation?
Consider a high-income investor that has $2 million invested in the S&P 500, with $1 million in a 401(k) and $1 million in a taxable brokerage account. Based on current dividend yields, such an investor would receive a total of about $27,000 in dividends in a year. That total would be split in half between the 401(k) and taxable brokerage account ($13,500 in each). Only the dividends in the taxable brokerage account ($13,500) would be subject to dividend taxation, and that would amount to approximately a $4,900 tax bill for the year on just dividends at the "preferential" 36% tax rate.
A More Thoughtful Approach
An investor who wants to purchase the S&P 500 could divide that index into two components:
1) Lower dividend paying stocks in the S&P 500, as proxied by the S&P 500 Growth Index
2) Higher dividend paying stocks in the S&P 500, as proxied by the S&P 500 Value Index
Holding half of a portfolio in the S&P 500 Growth Index and half of a portfolio in the S&P 500 Value Index can approximate the same expected risk and return profile of the whole S&P 500 Index. The benefit of creating a synthetic replica of the S&P 500 with those two underlying components is that higher dividend paying stocks can be concentrated in a tax protected retirement account.
To illustrate how this strategy can lower taxes, again consider the same high-income investor as before with $1 million in a 401(k) and $1 million in a taxable brokerage account. Instead of holding the S&P 500 Index in both of those accounts, the investor could hold the S&P 500 Value Index (i.e. higher dividend paying stocks) in the 401(k) and the S&P 500 Growth Index (i.e. lower dividend paying stocks) in the taxable brokerage account.
Based on current yields, such an investor would still receive about $27,000 of dividends in total for a year, but approximately $20,000 of those dividends would be concentrated in the 401(k) account and only $7,000 of the dividends would remain in the taxable brokerage account. This would cut dividend taxation nearly in half compared to the “Base Case” illustration, reducing the tax bill from approximately $4,900 to only $2,500.
This is only an illustration and the numbers will of course change based on how dividend yields and tax rates differ from investor to investor over time. The core lesson is that investors with more assets and higher taxes stand to benefit more from this strategy as their savings and income grow.
The example above illustrates how high-income investors can potentially save thousands of dollars without any significant changes to their risk and reward profile. By taking more care in deciding where to hold which investments, an investor can improve their after-tax outcomes without contributing more to retirement savings or changing their overall investment profile.
At Andante Financial, our mission is to elevate the standard of investment management. To learn more about how we use this and many other strategies to enhance our clients' financial wealth, click the link below.