Summary

Investors must consider the tax implications and company signals when deciding between receiving returns as dividends or capital gains.

Abstract

The article "Investment 101: Dividends vs Capital Gains" discusses the two primary forms of investment returns: dividends and capital gains. Dividends are cash payments made to shareholders, while capital gains are the profits realized from selling an asset at a higher price than it was purchased. The article highlights the importance of understanding how these returns are taxed differently, with dividends being taxed annually and capital gains only upon the sale of the asset. It also explores the implications of a company's dividend policy, which can signal financial health and future profitability, as seen in the case of Microsoft. The article concludes by emphasizing the need for investors to weigh tax liabilities and the signals sent by a firm's payout decisions when making investment choices.

Opinions

The author suggests that the choice between dividends and capital gains is complex and influenced by tax considerations, especially for taxable investors outside of retirement accounts.
Retirement accounts, such as 401k and Roth-IRA, offer tax-deferred incentives that can influence the preference for dividends or capital gains.
Historical tax rates on dividends have varied significantly, with notable changes during the Carter and Reagan administrations, and more recently with the Bush administration's tax cuts in 2003.
The author posits that a company's decision to pay dividends, as in the case of Microsoft, can signal to investors that the firm is financially stable and committed to profitable ventures.
A reduction in dividend yield, such as that observed in the S&P 500 from 1980 to 2014, can be beneficial for taxable investors as it lowers their tax liability and allows for more control over the timing of tax events.
The article opines that investors should consider both the immediate tax implications of dividends and the potential for capital gains to provide more after-tax return flexibility.

Investment 101: Dividends vs Capital Gains — How to keep more of your money in your pocket?

If you own a stock, would you prefer to receive returns from that investment in the form of capital gains or dividends?

What are the types of returns?

The return of a security or asset is the change in price plus any cash payout received normalized by the beginning-of-period price.

Example 1: If you bought 100 shares of Microsoft (MSFT) at the beginning of 2020, the stock rose $20 per share. Your return on that investment would be $2000 due to price appreciation. This return is classified as capital gains. At the same time, MSFT pays an annual dividend of $2.48 per share. This type of return is cash dividend.

Example 2: If you own some real estate, the dividend is the rental payment you get from the tenants. If the real estate gains in value, the value appreciation you gain when you sell the property is capital gains.

Publicly-traded firms have corporate dividend policy, which determines the type of return stockholders receive (i.e: cash dividend or capital gains).

The firm payout choice signals to investors the financial status of the company.

Should they pay out their earnings as cash dividends to investors, or should they reinvest their earnings back into the firm? Lastly, should they use earnings to repurchase the firm’s own stock to boost the stock price?

How should a firm payout affect your investment decision?

The key question here is: Would you like your returns in price appreciation (capital gains) or would you like a cash payout (dividend)? It’s certainly a complicated question and I would like to present several reasons why both options are appealing.

Dividend payout choice:

Tax considerations are most important for taxable investors. Retirement accounts (e.g: 401k, Roth-IRA, …) have tax-deferred incentives. However, if you invest your money outside of retirement accounts — your taxable money, you will need to consider tax when investing in a dividend stock.

Dividends are taxed on an annual basis (like working wage and interest). You get dividends this year, you will pay on these dividends the same year, the same tax rate you would for your labor income.

The maximum rate for dividends (the tax rate for highest income people) were 90% in the 1950s and 1960s. By Jimmy Carter years, that rate fell down to 70%, and continued to fall down during Reagan years. Up to 2003, the dividend rate was set at the same rate as your labor income. In 2003, the Bush administration introduced tax cut, and the dividend maximum tax rate was set to 15%, falling approximately 20% from previous year.

Currently, the capped tax rate for qualified dividends is 20%. Qualified dividends are defined as: 1/ dividends paid by a U.S. corporation after December 31, 2002, 2/the dividend stock were held more than 60 days before the ex-dividend date — the first date following the declaration of a dividend.

Capital Gains payout choice:

Capital gains are also taxed, but they’re only taxed when you sell the stock.

For example: If you purchased ABNB and the stock goes up $20 per share in value, you’ll pay tax on that gain when you sell your ABNB shares. However, if you don’t sell ABNB, you will have an unrealized gain of $20 per share and you don’t pay tax on that gain this year.

Tax rates on capital gains differ based on how long you owned the stocks before selling it (i.e: short-term versus long-term status).

For short-term capital gains — price appreciation by holding a stock for less than a year, the tax rate is the same as your wages. In contrast, the long-term capital gains were also cut back to 15% in 2003. Currently, the capped tax rate for long-term capital gains is 20%, the same as that of qualified dividends. However, unlike qualified dividends, you don’t have to pay taxes unless you sell the stocks.

Case study 1: Microsoft

Thanks to the revolution of personal computers, Microsoft has grew dramatically from 1980s to 2000s. Investors in Microsoft stock saw big changes in the composition of returns over the period 1986–2002.

Pre-2003, all returns were changes in the stock price, no cash dividends were paid. Between 2003–2012, the stock price was essentially unchanged at $27 so no capital gains were realized. However, $7.54 in cash dividends were paid per share during this period.

The decision to start paying dividends send signals to Microsoft investors that the firm is cash-rich to afford a stream of cash payments. Committing to dividends sends a signal that a firm will not waste resources on bad projects. Furthermore, paying dividends can signal that a firm has arrived and expects to be consistently profitable in the future.

Case Study 2: Dividend Yield of S&P 500 from 1980–2014

Average S&P 500 returns are 12–13% over the period of 1980–2014. Dividend yield has fallen approximately 3/5th over this period (from 5% to 2%).

If you invest in the S&P after 2014, you are getting more return in capital gains than in dividends. Having reduced dividend yield potentially reduces tax liability incurred by taxable investors.

Taxable investors have to pay taxes on dividends when investing through taxable account (non-retirement accounts). If you’re given capital gains, you have the discretion of when to sell the assets and incur the tax. Thus, lower dividends means lower taxes for your portfolio overall.

For a publicly traded firm, the same logic can be applied. Simply reducing dividends and their investors’ associated tax liability would give investors more money to invest, thus increasing the firm value.

Summary & Key Takeaways:

When investing in an asset (stock, index fund, real estate, etc), you can have returns in the forms of price appreciation (capital gains) or cash payout/rental payment (dividends).
For taxable investors, both types of payout choice — dividends or capital gains — pose consequences for their after-tax return.

Dividends are taxed on annual basis at the same rate as labor income.
Qualified dividends (for stocks held more than 60 days before ex-dividend date) are taxed at the capped rate of 20%.
Short-term capital gains (holding period less than 1 year) are taxed at the same rate as labor income.
Long-term capital gains (holding period more than 1 year) are taxed at the capped rate of 20%. Unlike qualified dividends, you don’t have to pay taxes unless you sell the stocks.

3. When thinking about stocks that pay dividends or not, you not only want to think about tax liabilities, but also the potential useful signals sent by the firms making these dividend payments.

Microsoft started paying dividends in 2003 to show investors that the company is consistently profitable, and will not waste its cash reserves on bad projects.
S&P yields an average return of 12% since 1980, and has steadily reduced its dividend payment from the high of 5%. This effectively reduces tax liabilities of its taxable investors.

If you make it this far, congratulations! Thank you for reading my post on tax-related investment guide. For more of my investment guides, please check out this list.