Should You Care About Dividends?

Should You Care About Dividends?

What can an advisor or individual investor say about dividends? Can he or she say anything about the companies that pay (or don’t pay) them? Should an advisor pay special attention to dividend-paying, dividend-growing, companies? This article is an attempt to discuss the topic of dividends from the perspective of the individual investor and his or her financial advisor. Its four sections are not meant to be comprehensive. Rather, it aims to be educational and to discuss the merits (and demerits) of owning dividend paying stocks relative to what is often cited as their alternative – bonds and “growth stocks.”

Round One: Tax Advantages

One potential advantage dividend payments have over the interest income an investor would receive from owning bonds is favorable tax treatment. From the IRS’s point of view, interest income is subject to ordinary income tax-rates. Therefore, and depending on your adjusted-gross annual income, the tax you pay on interest income can greatly exceed the tax you would pay on qualified dividends. For example, imagine a couple in their mid-50s earning a combined salary of $487,451 in 2024 with total taxable interest income of $125,000. 1 This

$125,000 is subject to a 35% tax-rate – the 2024 federal marginal tax-rate on ordinary income above $487,451. This equates to $43,740 owed in taxes, leaving the couple with $81,250. Were the same income stream to come from qualified dividends, which are subject to a 20% tax-rate, the couple would owe (only) $20,185 in taxes, resulting in real, “cash-in-the-pocket” savings of $23,554! 2

Round Two: Income Stream

A 5% coupon (interest rate) on a bond trumps a 3% dividend yield on a stock, right? Well, that depends.

Suppose you have a 15-year time horizon and are debating between two alternatives.

Option #1: You invest $100,000 today in a bond portfolio that pays an annual 5% coupon (interest rate). You receive

$5,000 each year for the next 15 years and are able (miraculously) to reinvest your coupons in similar bonds that also yield 5%. At the end of the 15-year period, you have: $207,893. Your 15-year annualized compound pre- tax return: 5%.

Option #2: You invest $100,000 in a combination of dividend paying stocks; the weighted average dividend yield of which is 3%. As is not uncommon, let us assume the weighted average dividend growth rate of this portfolio is 8% per year and that your shares appreciate at a rate of 5% per year. You automatically reinvest your dividends. At the end of the 15-year period you have: $334,368. Your 15-year annualized pre-tax return is 8.4%.

What happened? Option #2 outperforms by over 3.0% per year. Seems like a small amount. It is not. Compound- ed over the 15-year period the results are extraordinary, resulting in an additional gain of over $125,000!

Over the long term, our balanced portfolio of dividend paying, dividend growing stocks provides significantly better purchasing power protection than a bond portfolio with a much higher starting yield of 5%.

To really drive the point home: assume the amount is $500,000 and the time period is 20-years. Dividend Portfolio Ending Value: $2.287mm, Bond Portfolio Ending Value: $826K

Round Three: Risk

In this category, bonds win. Without question, bonds are less risky than stocks. 3 A balanced portfolio of bonds will be less volatile than a balanced portfolio of stocks. There is no such thing as a safe dividend and a dividend cut can represent a devastating loss for an income-focused investor. However, as we alluded to above, the safety bonds offer is paid for in a loss of purchasing power. Depending on the economic environment, that price can be quite expensive.

Round Four: Mindset

The relative advantages of dividend-focused investing yield significant fruit only after an investor has weathered multiple years (typically more than seven) of owning the company or fund. In a world whose pace seems to quicken every other day, a commitment of that duration cultivates patience, prudence, compassion and a host of other positive attributes. These attributes are necessary for long- term wealth creation and are conducive to a healthy advisor-client relationship, but they are also values we seek to cultivate in other aspects of our lives: our friendships, our relationship or marriage, the way we approach strangers, so on and so forth.