dividends: what am I missing?

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OakPhilliesFan
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dividends: what am I missing?

Post by OakPhilliesFan » Sun Apr 17, 2016 1:43 pm

It seems relatively common to praise a stock or fund for giving out consistently high dividends. Sometimes I've even seen high dividend stocks suggested as an alternative to bonds in the current environment (although I think those folks are underestimating the risk!). But I am having some trouble understanding the purpose of dividends in various phases of investing.

I'm in my mid-30s, so have a lot of accumulation ahead of me. I reinvest all of my dividends. My investments are all in tax-deferred accounts, so there isn't much else I can think of to do with them. I suppose I could send them to a money market account and use them for rebalancing. But I currently have everything in a Vanguard Target Retirement fund, so rebalancing isn't necessary.

What about people who are in the withdrawal phase? Here I've seen distinctions between "current income" and "capital appreciation". However, as I understand it, dividend distributions cause the NAV to decrease. So your "income" is actually causing your capital to depreciate slightly! Wouldn't it make just as much sense, if not more sense, to reinvest the dividends and sell shares when you need the income? Why are dividends "income" whereas selling shares is considered reducing capital?

I feel like I must be missing something basic here, but I just don't know what it is. I can summarize the question as follows: when and why do dividends ever make a difference in investment decisions?

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Yesterdaysnews
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Re: dividends: what am I missing?

Post by Yesterdaysnews » Sun Apr 17, 2016 1:55 pm

Mostly people see consistently increasing dividends by a company as a sign of a well run, healthy and mature company. I think you are correct that it is probably better to view things from a "total return" point of view rather than obsess over dividends.

I personally am not a huge fan of dividends as they basically force you to pay taxes even if you are in the accumulation phase and don't really need the dividend payout for income.

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timboktoo
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Re: dividends: what am I missing?

Post by timboktoo » Sun Apr 17, 2016 1:56 pm

This is an oft-discussed topic here. I would encourage you to use the search feature on the site to look at previous discussions about dividends vs. total return.

In my opinion, you are quite right. Whether your return comes mostly from a dividend or mostly from capital appreciation or from a combination of the two, the effect is the same. Were dividends taxed at a different rate than capital gains, a different discussion would be had on the merits of using one above another. But for the time being, there is no mathematical difference between these two approaches insofar as they have to do with withdrawals.

There are many roads to Dublin, however. Were an investor to decide that dividends were important for their ability to stay the course, I would not want to steer them away from that decision, so long as they still maximized their tax-advantaged space, minimized costs, were very diversified and did not take excessive risk. We all have different philosophies and those philosophies shape our portfolios just as much as our rational minds do.

- Tim

dbr
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Re: dividends: what am I missing?

Post by dbr » Sun Apr 17, 2016 1:59 pm

To a portfolio I apply the concept of return (total return in some parlance but I don't think there is any other kind of return). In addition to return I apply the concepts of contributions (investment, accumulation) and withdrawals (disinvestment, deccumulation or something).

To household cash flow I apply the concept of income. For me there is a well defined boundary that when I move money across that boundary it is positive or negative income to cash flow and contribution or withdrawal from the portfolio.

This is a little different from the classic accounting or economic definitions, but I think it is the best framework for the individual investor to get straight about what is happening. People that don't want to think that way don't have to. It is, however, helpful if how they do think makes sense of things and does not lead to bad thinking about investing.

longinvest
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Re: dividends: what am I missing?

Post by longinvest » Sun Apr 17, 2016 2:14 pm

Look at our wiki's VPW.

Using VPW with a rebalanced Three-Fund Portfolio combined with lifelong guaranteed income streams (Social Security, pension if any, inflation-adjusted SPIA if necessary) is simple and protects against premature portfolio depletion during retirement.
Bogleheads investment philosophy | Lifelong Portfolio: 25% each of (domestic / international) stocks / domestic (nominal / inflation-indexed) long-term bonds | VCN/VXC/VLB/ZRR

larryswedroe
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Re: dividends: what am I missing?

Post by larryswedroe » Sun Apr 17, 2016 2:14 pm


sport
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Re: dividends: what am I missing?

Post by sport » Sun Apr 17, 2016 2:15 pm

Dave81 wrote:What about people who are in the withdrawal phase? Here I've seen distinctions between "current income" and "capital appreciation". However, as I understand it, dividend distributions cause the NAV to decrease. So your "income" is actually causing your capital to depreciate slightly! Wouldn't it make just as much sense, if not more sense, to reinvest the dividends and sell shares when you need the income? Why are dividends "income" whereas selling shares is considered reducing capital?
In the withdrawal phase, dividends from a taxable account that are needed for spending should not be reinvested and shares sold later for spending. The reason is taxes. When the dividends are paid, taxes are owed on those dividends whether or not they are reinvested. If they are reinvested, and the shares are sold later, additional taxes may be due. In an IRA account, it would not make any difference.

snarlyjack
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Re: dividends: what am I missing?

Post by snarlyjack » Sun Apr 17, 2016 2:58 pm

This is a fun conversation...

In my mind it's all about compounding.
Think of a pyramid, it's wide & tall.

In the accumulation phase the dividends buy more shares
making the pyramid wide. The growth of the shares make
the pyramid tall. Between the two (growth & dividends)
you have a very strong pyramid (foundation).

In the distribution phase the dividends can supply a
very nice retirement distribution.

Of course this is just a very simple visual picture...but what
you want is wide & tall. Another visual is the dividends are the after burners
of a fighter jet...the dividends help you gain altitude...

blueberry
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Re: dividends: what am I missing?

Post by blueberry » Sun Apr 17, 2016 3:09 pm

I'm recently retired, low income for now, and really enjoying occasionally taking money from my savings accounts and cds and buying moderate paying dividend stocks, the income from which will be taxed at a low rate. Many of the moderate dividend producing stocks are low volatility, also good for retirement. I don't want to have to sell stock to have spending money, first analyze gain/loss, upside potential, etc. Dividends are a simple income stream. I had no interest in dividend stocks before I retired.

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House Blend
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Re: dividends: what am I missing?

Post by House Blend » Sun Apr 17, 2016 4:37 pm

timboktoo wrote:In my opinion, you are quite right. Whether your return comes mostly from a dividend or mostly from capital appreciation or from a combination of the two, the effect is the same. Were dividends taxed at a different rate than capital gains, a different discussion would be had on the merits of using one above another. But for the time being, there is no mathematical difference between these two approaches insofar as they have to do with withdrawals.
Let's set aside short term vs. long term and qualified vs. non-qualified, and work in the idealized world where all gains are long term and all dividends are qualified. (And both are taxed at the same rate.)

Having done that, there is a still a mathematical difference between dividends and capital gains. And the difference is such that cap gains are preferable for everyone, including retirees.

The point is that capital gains taxes apply only to the part of a sale that represents profit, whereas a dividend distribution is like a sale whose proceeds are entirely profit.

Consider two retirees that have 25 years to spend their (taxable) nest egg. They pay nonzero amounts of tax on dividends and capital gains..
A has a fund that distributes 3% in dividends every year, which he spends.
B has a fund that generates the same total return but pays no dividend.
She sells 3% of assets every year.

Then A and B will end up with the same account balance at the end of 25 years, but B will have had more net income, because she will have paid less income tax each year on her 3%.

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patrick013
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Re: dividends: what am I missing?

Post by patrick013 » Sun Apr 17, 2016 5:33 pm

Married filing jointly - cap gains and/or qualified dividends equal
$75,000 - no taxes paid anyway.

$75,000 in common interest results in $7,241 in federal tax.

Sometimes diversification can result in a higher tax bill obviously.
So risk has it's tax benefit reward too it shows.
age in bonds, buy-and-hold, 10 year business cycle

Clive
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Re: dividends: what am I missing?

Post by Clive » Sun Apr 17, 2016 6:02 pm

House Blend wrote:Consider two retirees that have 25 years to spend their (taxable) nest egg. They pay nonzero amounts of tax on dividends and capital gains..
A has a fund that distributes 3% in dividends every year, which he spends.
B has a fund that generates the same total return but pays no dividend.
She sells 3% of assets every year.

Then A and B will end up with the same account balance at the end of 25 years, but B will have had more net income, because she will have paid less income tax each year on her 3%.
If A's dividend were reinvested (buy more shares of A) and if B used the amounts that might otherwise have been paid as dividends to repurchase stock, then for the same earnings B's earnings per share will advance quicker than A's - which may very well advance the share price faster making any synthetic dividend (selling some shares) more 'efficient'. B can also be more tax efficient than A - that pays a dividend that is taxed and incurs costs to reinvest.

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fortyofforty
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Re: dividends: what am I missing?

Post by fortyofforty » Sun Apr 17, 2016 6:35 pm

If taxes weren't a factor, there would be no practical difference between dividend paying stocks and growth stocks. Traditionally, companies that are old and stable enough to generate excess cash eventually run out of things to do with the money in terms of furthering their business. So, they can either buy back shares, pay dividends, or some combination of the two. There are indeed many people who do not like to have to sell shares to raise spending money. It may be psychologically important. That shouldn't be discounted. They might sell the "wrong" shares at the "wrong" time. The two sides, pro-dividend and anti-dividend, are entrenched, and they are both right, in their own way. The third position (mine) is neutral, as there is merit to both arguments. As mentioned above, this has been discussed ad nauseam in this forum. Search and read. You'll have many years' worth of reading ahead of you.
"In a time of universal deceit, telling the truth becomes a revolutionary act." - George Orwell | There are many roads to doublin'. | Original Vanguard Diehard

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patrick013
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Re: dividends: what am I missing?

Post by patrick013 » Sun Apr 17, 2016 6:38 pm

Dave81 wrote:
I feel like I must be missing something basic here, but I just don't know what it is. I can summarize the question as follows: when and why do dividends ever make a difference in investment decisions?
Dividend stocks have less risk, higher income, but less cap gains. Generally,
a fund like the 500 is better for the accumulation phase. A govt. bond fund can
buffer a retirement fund quite well if it can sustain for several or more years
spending cap gains in retirement. A dividend fund also. Many like keeping
the 500 type fund thru retirement but I always remember Bernstein here:

Bernstein: At the opposite end of the spectrum, the average
70-year-old has no margin for error; low returns immediately
following retirement combined with withdrawals can drain a
stock-heavy nest egg faster than you can say ‘financial crisis'.

Here's a related spreadsheet showing income, risk, and potential
market drawdown. The AA of the income portfolio could be
adjusted I think.

Image

Dividends do not affect price appreciation (PE price/earnings ratio)
but do affect total return. Studies have proven that.
age in bonds, buy-and-hold, 10 year business cycle

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timboktoo
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Re: dividends: what am I missing?

Post by timboktoo » Sun Apr 17, 2016 10:32 pm

House Blend wrote: Let's set aside short term vs. long term and qualified vs. non-qualified, and work in the idealized world where all gains are long term and all dividends are qualified. (And both are taxed at the same rate.)

Having done that, there is a still a mathematical difference between dividends and capital gains. And the difference is such that cap gains are preferable for everyone, including retirees.

The point is that capital gains taxes apply only to the part of a sale that represents profit, whereas a dividend distribution is like a sale whose proceeds are entirely profit.

Consider two retirees that have 25 years to spend their (taxable) nest egg. They pay nonzero amounts of tax on dividends and capital gains..
A has a fund that distributes 3% in dividends every year, which he spends.
B has a fund that generates the same total return but pays no dividend.
She sells 3% of assets every year.

Then A and B will end up with the same account balance at the end of 25 years, but B will have had more net income, because she will have paid less income tax each year on her 3%.
Sorry, I don't understand. Taxes on qualified dividends are 15%, correct? And taxes on capital gains are 15% for long-term stocks right? I am missing something. If person A spends their dividend and person B withdrawals 3%, aren't they both paying the same that in year in taxes on what they've earned or sold? After 25 years, how do things change? How is person B paying less income tax each year?

I'm sorry if I've missed something quite obvious.

- Tim

sport
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Re: dividends: what am I missing?

Post by sport » Sun Apr 17, 2016 10:41 pm

timboktoo wrote:Sorry, I don't understand. Taxes on qualified dividends are 15%, correct? And taxes on capital gains are 15% for long-term stocks right? I am missing something. If person A spends their dividend and person B withdrawals 3%, aren't they both paying the same that in year in taxes on what they've earned or sold? After 25 years, how do things change? How is person B paying less income tax each year?

I'm sorry if I've missed something quite obvious.

- Tim
When person A gets the dividend, the entire amount is taxable. When person B withdraws the same amount, only the gain is taxable. In fact, if there is no gain, there is no tax.

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timboktoo
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Re: dividends: what am I missing?

Post by timboktoo » Sun Apr 17, 2016 10:43 pm

sport wrote: When person A gets the dividend, the entire amount is taxable. When person B withdraws the same amount, only the gain is taxable. In fact, if there is no gain, there is no tax.
Now I see. Thank you.

- Tim

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