Careful thinking about dividends would lead investors to think of them quite differently.
Today’s post will continue the discussion on dividends and the complications and confusion that often surround them. Hopefully, the detailed examples will shed light on some of the denser components.
In The Real World There Are Frictions
Unfortunately, we don’t live in a world without frictions. And where frictions exist, they can lead us to prefer capital gains over dividends, or vice versa. For example, if dividends are taxed at higher rates than long-term capital gains (as they once were) taxable investors would have a clear preference for capital gains.
But even with the current tax regime, taxable investors should prefer capital gains, because when creating a self-made dividend, you could sell only the shares that would receive long-term capital gains treatment, and taxes would be due only on the portion that is a gain, not the total amount. With dividends, you’re taxed on the full amount.
In addition, investors can manage taxes by choosing the highest cost basis lot to sell, minimizing taxes. And if there are losses on the sale, the investor gains the benefit of a tax deduction. Even in tax-advantaged accounts, investors who diversify globally—which is the prudent strategy—should prefer capital gains, because in tax-advantaged accounts, the foreign tax credits associated with dividends have no value.
Finally, if dividends were throwing off more cash than needed to meet spending requirements, the total return approach would benefit from not only the time value of not having to pay taxes on the “excess” amount of dividends, but dividends could also push investors into a higher tax bracket.
It’s also possible that investors could prefer dividends. The reason would be transactions costs. Let’s assume that all assets are in tax-advantaged accounts and all assets are domestic. In this situation, taxes don’t create any frictions. If the creation of self-made dividends does incur transaction fees that could have been avoided by a cash-flow approach—as in dividends providing the cash flow—then those fees could lead to a preference for cash dividends.
In today’s world, with very low commission rates, and with many mutual funds trading at no costs, this is not likely to be much of an issue.
There’s one other point to consider. There often isn’t much difference in the yield of dividend strategies versus the yield on either more market-like strategies or the yield on value-oriented strategies. For example, the current yield on the SPDR Dividend ETF (SDY | A-72) is about 2.3 percent. The current yield on Vanguard’s Total Stock Market Fund is about 1.7 percent, just 60 basis points percent lower than SDY’s.
For a typical 60 percent stock/40 percent bond portfolio, to make up for the lower dividends, an investor would have to sell just 0.36 percent of the stock portfolio to create that self-made dividend. And if the yield on Vanguard’s Value Index Fund is about 2.2 percent, just 10 basis points lower than SDY’s yield, the investor would have to sell just 0.06 percent of his stock portfolio.
For those interested in learning more about the differences between a cash flow and a total return approach using home-made dividends when needed to supplement the interest and dividends generated by the investment portfolio, Vanguard’s research team has a paper on this subject. The writers recommend using a total-return approach with the investor first deciding on an asset allocation that’s based on his or her unique goals and objectives, as well as their ability, willingness and need to take risk.
“This decision should be the investor’s highest priority,” the paper says.
They should then stick to their plan, rebalancing along the way as needed.