To Dividend, Or Not To Dividend

Throughout my 26 years of experience managing client investments, I've consistently observed the perception investors have that dividend-paying stocks are more stable and better performers than their non-dividend-paying counterparts. As practical and logical as it is to assume that shareholders are better off by receiving cash payments instead of hoping for appreciation, it’s not always the case. There is no evidence to support a positive link between stock performance and the amount and frequency of dividend payments. Investment performance is a function of the level of risk one accepts, not the level of dividends received.

Below is some information on Dividends:

Where do they come from?

Dividends are paid from company profits. Dividends are not legal obligations of the company; they are made at the company’s discretion. A payment of a dividend will lower the cash balance and book value of a company, which, all other things being equal, will reduce the company’s stock value by the same amount.

The following diagram illustrates the common choices that companies have involving the allocation of profits.

Dividend – The Company pays a dividend from its profits; it receives no tax deduction for dividends. The dividend is taxed either as ordinary income or capital gain to the investor (most dividends qualify for capital gain treatment). An investor in a non-qualified taxable (brokerage, trust) account is taxed on the dividend, whether the dividend is reinvested or not. The dividend is not taxed in a qualified retirement account (IRA, 401K, 401(b), Roth IRA) unless the dividend is distributed, and then taxed as all other income from a qualified account – ordinary income.

Retained Earnings – The Company foregoes paying a dividend and reinvests funds in the company for purposes such as research and development, expansion, or capital equipment purchases. The investor does not receive a dividend.

Repurchase Stock – Otherwise known as “Stock Buybacks.” The company uses its profits to purchase its shares in the public market. The result is fewer shareholders and, therefore, a higher stock value per shareholder and an increased dividend. The repurchase of a company’s stock generally results in an increased stock price. A dividend declared will typically lower a stock price.

Dividend Example,
Company X earned $1 million in profits in the last calendar year. The company has issued 10,000 shares. The company declares a 2% dividend.

Total Stock Dividend (2% x $1mil)        $20,000

Total Shares Outstanding                           10,000
 Dividend Per Share                                $2 per share

A shareholder owning 100 shares of Company X would receive a $200 dividend.

Are Dividends A Good Income Source?

Because the cash flow from a stock investment can come in the form of a dividend or the sale of the stock, both are considered sources of income. The main question to ask yourself is, “Do I need the income?” If you do not, the dividends paid in a retirement account (IRA, 401(k), 403(b) that are reinvested arrive at the same result as if you had not received the dividend. If you need income, the withdrawals from retirement accounts will be taxed as ordinary income, and withdrawals from your non-retirement account are taxed at ordinary income or capital gains rate. The investor is concerned with performance, which includes price appreciation and dividends paid. Another alternative to receive a regular source of income would be the interest payments from bonds, but bond interest is taxed as ordinary income.

 Are Dividend-paying companies more stable than non-dividend-paying companies?

The largest U.S. companies usually pay annual dividends and are often called “blue-chip” stocks due to their consistent dividend-paying history. However, just because a company chooses to pay a dividend from profits each year, it doesn’t necessarily mean the stock is a better investment than non-paying dividend companies. For example, if the earnings of a dividend-paying company are average year to year, the market will “price-in” the cash reduction along with slower growth, and the stock value may decline relative to other investments.

Example,

The stock of Company X appreciated 10% during the last calendar year. Including the 2% dividend payment, the total return was 12%.

Do Dividend-Paying Stocks  Achieve Higher Returns?

 Unfortunately, there is no evidence to conclude that stocks that pay dividends outperform non-dividend stocks over the long term. Investment performance is based on the amount of risk an investor accepts. Companies that have consistently paid dividends over time are usually companies that fit into the “large-cap” category and have lower risk and lower expected returns over time.

 What are The Tax Considerations of Dividends?

Dividends paid in a non-qualified (brokerage) account are taxed at either ordinary income rates or the capital gain tax rate. Dividends paid inside a qualified plan (401K, IRA, etc.) grow tax-deferred and are taxed as ordinary income only when withdrawals are made. Since most dividends paid qualify for capital gain treatment, there is little difference in the net tax. However, to qualify for a capital gain on the sale of a stock, you must hold the security for at least a year; the holding period to qualify for dividend capital gain treatment is 121 days (60 days before and 60 days after the ex-dividend date).

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Financial goals are predominantly funded through income payments and investment withdrawals. Income payments include social security, pensions, annuities, rental, royalties, business, etc. Dividends fall into investment withdrawals. The decision to focus on dividend-paying stocks requires analysis of various factors, including the type of retirement account, the type of companies (riskier or conservative), the need for income for living expenses, and overall risk tolerance. We have expertise involving investments, taxes, and financial planning.

Please feel free to visit our website and call (925) 484-1671 or contact us if you have a question or would like to schedule a no-charge consultation.

• Past Performance is no guarantee of future results

• No investment process is free of risk; no strategy or risk management technique can guarantee returns or eliminate risk in any market environment.