One of the things investors frequently fail to realize is the effect that taxes can have on the overall wealth accumulated in their dividend growth portfolio.
Creating Wealth Through Dividend Growth Investing
Investing in dividend growth companies is one of the best ways to create long term wealth. Companies with a proven history of paying out annually increasing dividends tend to be amongst the best companies in the world. If a company can continually grow their dividend payments year after year, then most likely they are growing their earnings and value. Many dividend growth companies are blue chippers amongst the greatest companies in the world. Companies such as Coca-Cola, Johnson & Johnson, Procter & Gamble, Wal-Mart and McDonald’s are all industry leading dividend growth companies.
The idea behind dividend growth investing involves purchasing shares of high quality companies with a history of paying out annually growing dividend payments to shareholders. Dividend growth investors plan on holding their shares for the long term and allowing the companies to do their jobs of creating and growing in value for the owners. The companies purchased by dividend growth investors will pay out a portion of their earnings in the form of dividend payments to the shareholders. The best companies will grow their dividend payments annually at a rate higher than inflation.
Investors will build their nest egg by continually buying and holding long term the best dividend growth stocks available. They will also take the dividend income received from the companies owned and reinvest in more shares of quality dividend growth companies. Eventually, the investor will create a portfolio large enough where the dividend income received from companies owned is large enough to cover all of the investor’s financial needs. This point is called financial independence. Once an investor reaches financial independence, the investor can then use their dividend income to spend and cover their living expenses rather than reinvesting to try to continue to grow their wealth.
The ultimate goal of most dividend growth investors is to create a large enough portfolio of dividend growth stocks where the investor can ultimately live off of the dividend income paid out by the companies they own.
The Effects of Dividend Taxes on Your Wealth Creation
While creating wealth through dividend growth investing is a fairly easy process, many investors sometimes fail to take into consideration the amount of taxes they will need to pay relating to their investing activities. Since dividend growth investors mostly invest in dividend paying companies, they need to strongly consider the effect of dividend taxes on their overall wealth creation.
Starting in 2013 and going forward (until tax laws change), there are 6 different federal income tax brackets. Investors in the lower 2 tax brackets will pay no taxes on their qualified dividends (dividends are considered qualified if they come from stock that has been or will be held more than 60 days). Investors in the 25% to 35% brackets (including the 2 brackets in between) will have to pay a 15% federal tax on qualified dividends. Investors in the highest tax bracket will be required to pay a 20% tax on qualified dividend income.
What this means is that every year, investors will lose a portion of their dividend income towards federal coffers. Dividend investors will either need to use a portion of their dividend income to pay the taxes or use income from some other source.
Lets look at an example to see how dividend taxes can hinder your wealth creation:
Meet Joe. Joe is a plumber who is trying to invest some of his hard earned income so that one day he can relax and live off of those investments. Joe is a dividend growth investor because he likes the idea of buying assets that will pay him an income every year as long as he owns those assets. He also likes that the income he receives will most likely increase each year at a rate higher than inflation.
Joe has decided that he is going to invest $10,000 at the beginning of each year for 25 years. He will also reinvest all his dividend income in dividend growth stocks. Let’s assume that Joe is able to earn an average portfolio yield of 3.5%. We will also assume Joe is able to earn a return of 7% on his holdings.
Joe’s ending investment wealth without taking taxes into account would be just higher than $1.2 million earning him around $38,500 annually in dividend income.
However, because of taxes Joe’s wealth will be around $100k less (assuming Joe pays 15% rate on dividends) and only earn him roughly $30,000 per year in income. When taking taxes into account, Joe will be earning 22% less than if he did not have to worry about taxes.
The greater amount one has invested, the greater amount one will earn in dividend income and then the greater amount one will have to pay out in federal dividend taxes. As these numbers grow, the negative effect of taxes on ones wealth becomes higher and higher.
Capital Gains Taxes
Unfortunately, dividend taxes aren’t the only form of taxes that investors have to consider. When investors decide it is time to part with one of their holdings for one reason or another they will sell that stock at a gain or a loss. For stocks that we sell at a gain, investors will have to pay a capital gains tax.
Dividend growth investors should be buying and holding stocks for the long term (possibly forever). If you buy and sell a stock while holding it less than a year then you will pay the short term capital gains tax rate which is higher than the long term rate.
The more selling an investor does, the more he burdens himself with capital gains taxes. As dividend growth investors, it should be our goal to only sell stocks when absolutely necessary. The less selling a dividend growth investor does, the less effect capital gains taxes will have on their overall wealth creation.
Reducing Your Tax Burden
An investor can reduce their capital gains taxes by selling only when absolutely necessary. Only sell your stocks when the company fails to perform to your expectations. We should only be selling if a company we own starts struggling with financial performance or no longer meets our expectations of dividend growth. Another reason one might sell is if they absolutely need the capital for something.
Investors also may look into investing in dividend growth stocks through tax advantage accounts such as a traditional IRA or a Roth IRA for retirement investing. In both of these types of accounts, the investments and income is allowed to grow tax free. This means the investor will avoid paying the annual taxes on their dividend income. All of the dividend income can be reinvested. Which type of account is used will determine how the proceeds are taxed once the investor begins to make withdrawals in retirement.
Investors would be wise to consider eliminating some of their investment tax burden by utilizing one of the tax advantage accounts available (especially if saving for retirement).
