Stocks can provide two sources of returns: dividend payouts and stock price appreciation. An income portfolio typically consists of at least some dividend-paying stocks. If investors are considering allocating to an income portfolio or buying dividend-paying stocks, it is important to be aware of the major advantage and disadvantage of dividend income.
Let’s say a $100,000 stock portfolio is expected to deliver an 8% annual return. Consider the following three scenarios:
Scenario #1: After one year, the stock portfolio pays out $8,000 in dividends, and the portfolio is still valued at $100,000.
Scenario #2: After one year, the stock portfolio pays out $0 in dividends, and the portfolio is valued at $108,000.
Scenario #3: After one year, the stock portfolio delivers $3,000 in dividends, and the portfolio is valued at $105,000.
In all three scenarios, the portfolio delivered roughly the 8% expected return, either from dividends, stock price appreciation, or a combination of both dividends and stock price appreciation. This raises an important question: As an investor, are you indifferent among these three scenarios?
In academia, we often refer to dividends as a bird in the hand and to stock price appreciation as two birds in the bush. And, as the saying goes, a bird in the hand is worth more than two in the bush. Dividends are usually a more reliable form of return than stock price appreciation, which is less predictable and often not as consistent. In other words, if you want 8% returns, then scenario #1 is probably the safest way, and this is why dividend-paying stocks and income portfolios can be good investments.
Let’s say a $100,000 stock portfolio consists of 1,000 shares of a $100 stock. Consider the following two scenarios:
Scenario #1: Let’s assume the stock pays a $5 dividend per share, giving you $5,000 in dividend income. However, once the $100 stock pays the $5 dividend, the stock price should fall to $95 per share. The portfolio value is now $95,000. Of course, we cannot forget about taxes. Let’s suppose the tax rate is 20%. Therefore, you will pay a $1,000 tax on your $5,000 dividend income. You are left with $4,000 of after-tax income.
Scenario #2: Let’s assume the stock does not pay out a dividend. To get $5,000 in income, you can sell 50 shares. The remaining portfolio value is now $95,000. Let’s again suppose the tax rate is 20%. However, the tax amount depends on your capital gain. If you bought the stocks for $100 or more per share, then you owe no taxes. But if you bought the stock for as low as $1 per share, then you owe a 20% tax on your $4,950 capital gain, which means you owe $990 in taxes from selling 50 shares. This leaves you with $4,010 of income. That is, you have more after-tax income than in scenario #1, while the remaining portfolio value is the same as in scenario #1.
Of course, it is probably unlikely that you bought the stocks at only $1 per share. If you bought the stocks at $50 per share, then you would owe $500 in taxes on your realized $2,500 capital gain and you are left with $4,500 of after-tax income.
Overall, to receive income from a portfolio, it can be more tax efficient to sell stocks than to receive dividends.
By the way, you may think that receiving dividends or selling shares implies that the portfolio value will eventually go to zero. But do not forget that stock values are expected to grow over time, although there is no guarantee. If you think stock values will not grow, then you should be invested in fixed income or sitting in cash instead of owning stock. Therefore, you should expect that the above portfolio will not go to zero due to dividend payouts or due to substituting dividend payouts by selling shares, unless the dividend is higher than the expected return over time.
Now that you know the major advantage and disadvantage of dividends, you may wonder which is greater. The answer is that it depends on the investor. Some investors may favor the more reliable income that dividends provide, and therefore not care so much about the tax disadvantage of dividends. However, some investors may dislike paying annual taxes on dividends and may want to go after the two birds in the bush.
Freedom Advisors offers income strategies and model portfolios with target allocations across sub-advisors that focus on various income strategies. Equity income holdings typically include large companies that generate dividends, as well as exposure in specific sectors and asset categories that have historically generated higher levels of income.
Advisory services are offered through Freedom Investment Management, Inc. ("Freedom"), a registered investment adviser. Freedom does not provide tax or legal advice. The information contained herein is for informational purposes only. This is not an offer to sell securities or provide investment advice. Investment strategies carry varying degrees of risk to include total loss. The representations and opinions herein are the opinions and view of Freedom and are believed to be reliable but are not guaranteed by Freedom nor its affiliates. When applicable, sources used in forming Freedom’s opinion are cited, however, other sources may be available which contradict Freedom’s opinion, process, and methodology. Potential investors are advised to consult with their financial, tax and/or legal advisors prior to investing.