Our disciplined friend asks us: should I favor investments that pay dividends?
Dividends are one of the most important sources of income for many investors, especially those who require their investment portfolio to generate periodic income that will serve to cover their expenses.
But first, let us agree on a single and complete definition: dividends are the portion of a company’s profits that is distributed among its partners or shareholders. Dividends can have a fundamental reason, for example, the company does not need the excess cash accumulated to finance its operations, or a psychological reason, the distribution of dividends serves as a signal to indicate that its financial health is good.
Dividends are usually paid in cash, on a scheduled or extraordinary basis, or in shares. A cash dividend effectively reduces the company’s cash position, while a stock dividend operates as a capitalization, retaining the available cash position. Stock dividends are more common under conditions of financial uncertainty.
As for dividends, there are four dates to consider: the declaration date, which is when the board of directors decides to make the distribution, the cut-off or ex-dividend date, which is the first date on which the then current shareholders will not receive the dividend, the record date, which is when the dividend recipients are determined, and the payment date.
Financially, receiving a cash dividend implies not only a decrease in available cash but also an immediate reduction in the theoretical value of the company by the total amount of the dividend distributed. For these reasons, it sounds illogical and financial theory in general opposes the distribution of dividends in companies that could have generated value by reinvesting it in their operations. However, this also explains why new companies or companies in periods of accelerated expansion do not usually pay dividends and mature companies or companies with established market positions do. Despite the theory, companies are ‘forced’ to pay a dividend to make their shares look attractive to an investing public that still values them.
Of course, there is the possibility of reinvesting dividends by acquiring additional shares in the paying company. If future returns look good, and the need for cash is not pressing, investors can reinvest the newly earned dividend and in fact there are programs to do so automatically and at low cost.
In fact, the total return on an investment is usually calculated in different ways, one of them by comparing the initial and final value of the investment. Another, more complete, uses the initial value and the final value of the investment considering the dividends obtained throughout the period evaluated. Another assumes that the dividends were reinvested. To get a more realistic view of the profitability of an investment, it is a good idea to consider the dividends obtained and make the corresponding adjustments in the event that they have been reinvested.
Regular dividends are subject to income taxes like any other income, that is, subject to marginal rates that for this year range from 10% to 37%. However, there are categories of dividends that may be treated more beneficially.
For example, some dividends are considered ‘qualified’ when they come from U.S. companies, or from some foreign companies, and the investor held the position for at least 61 days within the 121 days beginning 60 days before the ex-dividend date. Qualified dividends are taxable at rates of capital gains, i.e., 0%, 15%, or 20%, and depending on the total income of the taxpayer.
Other types of dividends with differentiated tax treatments include returns of capital, which are not taxable and common in limited partnerships; dividends from funds that invest in federally tax-exempt debt securities, such as municipal bond funds; and portions of some dividends[1] from real estate investment trusts (REIT). Obviously, dividends received in tax-deferred accounts, such as IRAs or 401ks, are not taxable, as are dividends received in Roth IRAs. Finally, funds typically distribute dividends designated as ‘capital gains distributions’ which are taxed as long-term capital gains.
Finally, it is important to mention that -to our friend’s question- it is possible to optimize not only the flow of projected dividends but also their tax effects once the client’s financial and investment needs, as well as the available options of account and dividend types have been considered. A competent financial advisor can help you do this.
Notice: The information provided herein is for educational purposes only. Portfolio Resources Group does not guarantee the accuracy of any tax recommendation, as we do not provide tax or legal advice. Consult a tax professional to ensure that the recommendations are appropriate for your particular situation.
[1] A particular type of dividend in REITs is known as Section 199A, which carries a percentage deduction. A detailed explanation is beyond the scope of this article.