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How to Beat the Dividend Reinvestment Tax


Is it better to earn 10% per year or 12% per year?

If you answered "it depends," then you're on the right track.

One basic mistake many investors make is to focus on their gross returns, or returns before expenses like fees and taxes. This error is easy to make, particularly when it comes to taxation, a topic that is as boring as it is important.

One of the biggest tax drags on your investment returns is the dividend reinvestment tax, or the "penalty" you pay for receiving some of your returns in the form of taxable dividends. In the article below, we'll explain how dividend taxes can harm your retirement goals, quantify how much you could lose to taxes, and show you how to eliminate the negative impact of taxes in your portfolio.

Let's start at square one.

What is the dividend reinvestment tax?

Technically speaking, there is no such thing as a "dividend reinvestment tax." You won't find it in the tax code, nor will you find it on the IRS website. It's a phrase that investors use casually to refer to the lower after-tax returns earned on investments that pay a dividend.

In reality, the dividend reinvestment tax is just the dividend tax. From Uncle Sam's perspective, it doesn't matter whether you reinvest your dividends to buy more investments or use them to supplement your income; either way, a dividend is income, and income gets taxed.

Paper currency stuffed in a glass jar

Image source: Getty Images.

Depending on your marginal tax bracket , income you earn from qualified dividends can be taxed at a rate ranging from 0% to 23.8%. Unqualified dividends, which are treated as ordinary income, can be taxed at rates as high as 37%. But we'll have more to say about specific tax rates later.

The good news is that most dividends qualify for a tax rate that's lower than the tax rate you'd pay on the income you earn for going to work 40 hours a week. The bad news is that paying any amount in taxes, even a seemingly trivial amount, can set you back $100,000 or more at retirement. This isn't something you want to overlook.

DRIPs and dividend reinvestment taxes

Investors are most likely to encounter the dividend reinvestment tax when investing through a brokerage account or through a publicly traded company's dividend reinvestment plan ( DRIP ).

Many "blue-chip" companies  offer a DRIP that allows investors to buy shares and have their dividends automatically reinvested in more shares. These programs are wildly popular. In any given year, Realty Income , which bills itself as " The Monthly Dividend Company ," issues more than $10 million of stock through its dividend reinvestment program -- and it's just one of hundreds of DRIPs out there.

DRIPs are popular because they have three big advantages over purchasing stock through a traditional discount brokerage firm:

  1. No commissions. You usually have to pay a commission to buy shares of stock, but many companies eat the fees when investors buy stock with a DRIP. 3M , which makes everything from Scotch tape to sandpaper, is a legendary dividend growth stock . Its DRIP allows investors to invest in its stock with as little as $10, and reinvest their dividends, without paying any fees to participate, for example.
  2. Automation. One main advantage of a DRIP is that your dividends are automatically reinvested for you. You don't have to log into your account and place a trade to buy more stock when you receive a dividend. This eliminates the opportunity cost of having cash pile up in a brokerage account where it earns little to nothing in interest.
  3. Partial shares. Whereas brokers only allow you to buy whole shares of stock, DRIPs allow investors to buy partial shares of stock. So, while shares of Dr Pepper Snapple will set you back about $120 a pop (pun totally intended), if you use its DRIP, your dividend can purchase fractions of a share. That means DRIP investors can own, say, 10.52 shares of the famous soda company.

DRIPs help you avoid paying commissions and make reinvesting your dividends more convenient, but they also have one big downside: Most DRIPs are taxable, which means you have to pay taxes on dividends you receive, even if the dividends are automatically reinvested into stock.

This can lead to some really big surprises at tax time. Many people learn about the tax status of DRIPs the hard way when they receive a 1099-DIV tax form for all the dividends that were automatically reinvested the year before. Owing taxes on dividends can make the difference between getting a refund and having to cut a check to the U.S. Treasury when you file your taxes. It's not fun for anyone -- except the tax man.

The two types of dividends

Luckily, most dividends get privileged treatment from the IRS and are taxed at a rate lower than ordinary income. (Having your money work for you is often better than working for your money.) But not all dividends are created equally, and the tax you pay ultimately depends on the type of dividends you earn.

There are two types of dividends that companies can pay to their investors:

  • Qualified dividends. Most dividends are qualified dividends. These are paid by ordinary corporations, like McDonald's or Philip Morris International , and are generally taxed at the long-term capital gains tax rate , which is almost always lower than the rate you would pay on ordinary income. Most index funds and mutual funds try to invest only in companies that pay qualified dividends because of their favorable tax treatment. So, if you own stock funds, it's likely that these are the kinds of dividends you receive.
  • Unqualified dividends. This category generally includes dividends paid by entities that are not subject to corporate taxes. Real estate investment trusts ( REITs ), business development companies ( BDCs ), and master limited partnerships ( MLPs ) typically pay out unqualified dividends, which are taxed as ordinary income. Many index funds and mutual funds purposefully avoid companies that pay unqualified dividends, because investors -- particularly those who are in high tax brackets -- lose much of their dividend income to taxes.

Dividend taxes by type and bracket

Tax brackets for qualified dividends were changed in the 2018 tax year. The table below shows the tax rate that corresponds to a taxpayer's adjusted gross income based on their filing status in the 2018 tax year.

Long-Term Capital Gains and Dividend Tax Rate

Single Filer

Married Filing Jointly

Head of Household

0%

Up to $38,600

Up to $77,200

Up to $51,700

15%

$38,600 to $425,800

$77,200 to $479,000

$51,600 to $452,400

20%

Over $425,800

Over $479,000

Over $452,400

Additional 3.8% surcharge

$200,000 or more

$250,000 or more

$200,000 or more

Data source: IRS.

Note that some particularly high earners are subject to a 3.8% net investment tax, which dates back to the passage of Obamacare. Fool.com writer and financial planning guru Dan Caplinger explains the net investment income tax as follows:

Specifically, taxpayers who have adjusted gross income of more than $200,000 for single filers or $250,000 for joint filers will have to pay the tax on investment income that exceeds these threshold amounts. For instance, if a single filer has $190,000 in salary income and $20,000 in investment income, then the net investment income tax is imposed only on the $10,000 by which the total income of $210,000 exceeds the $200,000 threshold limit.

While this surcharge only applies to high-income earners, it effectively creates an additional capital gains tax bracket that can result in paying a tax rate of up to 23.8% on dividends that you earn from your investment portfolio.

Meanwhile, unqualified dividends are generally taxed as ordinary income and thus carry a higher tax rate than qualified dividends. Here are the tax brackets for ordinary income in 2018 based on your filing status and income:

Tax Rate

Single Filer

Married Filing Jointly

Head of Household

10%

Up to $9,525

Up to $19,050

Up to $13,600

12%

$9,626 to $38,700

$19,051 to $77,400 $13,601 to $51,800

22%

$38,701 to $82,500 $77,401 to $165,000 $51,801 to $82,500

24%

$82,501 to $157,500 $165,001 to $315,000 $82,501 to $157,500

32%

$157,501 to $200,000 $315,001 to $400,000 $157,501 to $200,000

35%

$200,001 to $500,000 $400,001 to $600,000 $200,001 to $500,000

37%

Over $500,000 Over $600,000 Over $500,000

Keep in mind that we have not addressed dividend taxes at the local level. Many states levy taxes on dividends, which can substantially increase the amount you pay in taxes on dividend income earned from a stock portfolio. Forty-one states levy taxes on capital gains , and California's rate is the highest at 13.3%.

How paying taxes on dividends affects your total return

To illustrate how the dividend reinvestment tax affects your total return (that is, capital gains plus dividends received), let's suppose you want to invest in the S&P 500 , an index that includes roughly 500 of the largest stocks on the U.S. stock exchanges. Stocks in the S&P 500 index make up more than 80% of the stock market's value, and coincidentally, more than 80% of them currently pay a dividend.

I built a model in which S&P 500 stocks return 8% per year for 40 years -- roughly equal to their historical performance. In this model, I assume that 6 percentage points of the annual return comes from capital appreciation, or the general increase in stock prices over time, while the remaining 2 percentage points comes from dividends. (The dividend yield of the S&P 500 is about 2% and has been for several years running.)

Depending on your marginal tax rate for dividends, an annual return consisting of 6 percentage points of capital gains and 2 percentage points of dividends can work out to a compounded annual return of much less than 8% per year when taxes on dividends are taken into consideration.

Tax Rate

0%

15%

20%

23.8%

Post-Tax Annual Return

8%

7.7%

7.6%

7.52%

Data source: Author calculations.

In this calculation, I've applied the tax rate only to the dividends, as you won't pay taxes on the capital gains until you sell the investment. This allows us to quantify the effect of taxes only on the dividends you reinvest from start to finish.

The difference in annual returns between the lowest tax bracket and highest tax bracket is less than 0.5 percentage points, which may seem like a rounding error. But over a period spanning several years or decades, these slight differences in returns can really add up.

Consider a scenario where an investor starts with $10,000 and makes additional investments of $10,000 every year thereafter, earning annual returns of 8% before taxes (6 percentage points from appreciation and 2 percentage points from dividends). The table below shows you how much money an investor would have at the end of a 40-year investment period, based on the taxes paid on dividends along the way.

Tax Rate

0%

15%

20%

23.8%

Account Balance After 40 Years

$2,797,810

$2,578,779

$2,509,908

$2,458,887

Data source: Author calculations.

In this example, the difference between the lowest tax rate (0%) and any other tax rate is more than $200,000 -- an amount of money that could safely allow you to withdraw as much as $8,000 more per year in retirement.

How to avoid the dividend reinvestment tax

Avoiding the dividend reinvestment tax is as easy as holding your investments in tax-advantaged accounts where investments can grow tax-free or tax-deferred.

  1. Tax-deferred accounts: Traditional individual retirement accounts (IRAs) and 401(k)s are the classic type of tax-deferred account. Your contributions are deducted from your taxable income, but any funds you withdraw in retirement are taxed as ordinary income. (This group also includes 403(b) and 457 accounts).
  2. Tax-free accounts: Roth IRAs and Roth 401(k)s are examples of tax-free retirement accounts. Roth contributions are not tax-deductible, but you do not pay taxes on your withdrawals in retirement. (The less common Roth 403(b) and Roth 457 accounts also fit here.)

Any of the account types above will shield your investments from taxes on capital gains and dividends, which makes a big difference over time.

Mind the limits on tax-advantaged accounts

The U.S. government needs tax revenue, so it isn't willing to let investors put unlimited sums of money into easy-to-access tax-advantaged accounts. That said, investors who use an IRA and 401(k) in tandem can set aside at least $24,000 per year in a tax-advantaged account, protecting every dollar from the dividend reinvestment tax.

Here are the 2018 contribution limits for each type of account:

Account Type

Younger than 50

Age 50 or older

IRA

$5,500

$6,500

401(k), 403(b), 457

$18,500

$24,500

Data source: IRS.

Whether you use an IRA or an employer-sponsored plan (401(k), 403(b), or 457) is a matter of personal preference. Many people contribute just enough to their employer-sponsored plan to maximize their employer match (that's free money you get for saving through your employer's retirement account) and then move on to an IRA, where they can choose from a much broader array of investments. That's because the typical 401(k) offers about 20 mutual funds, whereas investors can pick from tens of thousands of funds and individual stocks in an IRA.

Other people value convenience over control, so they simply pile money into their employer-sponsored plan until they hit the maximum for the year. That works, too. Frankly, considering that you can contribute more to an employer-sponsored plan, and the contributions can be automatically taken out of your paycheck, it is a lot easier not to bother with an IRA.

Remember that you're not limited to one type of account or another. You can invest through a workplace retirement plan and and IRA, and you can even split your IRA contributions between traditional and Roth-style accounts. Between an employer-sponsored plan and an IRA, most workers can put away up to $24,000 per year (or $31,000 if they're aged 50 or older), and that doesn't even include any employer match they may receive. That's a lot of money to shield from the dividend reinvestment tax, and you'd be wise to use it.

Do dividends matter?

After reading so much about the downsides of dividends, you might think dividend-paying stocks aren't worth your time. That's simply not the case.

In truth, dividend stocks can be excellent investments. The Financial Analysts Journal published a study titled "What Difference Do Dividends Make?," which evaluated the performance of stocks based on the dividends they paid. It ultimately concluded that dividend-paying stocks have historically generated better returns with less volatility than non-dividend-paying stocks by a wide margin over almost any sufficiently long period of time.

Other research comes to similar conclusions. Ned Davis Research studied the performance of S&P 500 stocks from 1972 through 2016.  For each year, it put stocks into various categories based on whether they paid a dividend or not and whether the dividend was increased, reduced, or kept the same in the preceding 12-month period. What stands out in Ned Davis' findings is that dividend-paying companies' total return averaged 9.1% per year -- far better than the 2.4% annualized return of S&P 500 companies that had not paid a dividend in the most recent year.

In other words, if you had invested your money only in the S&P 500 stocks that paid a dividend, you would have done much better than if you had invested in all S&P 500 companies, dividend-paying or not, and it wasn't even close. The dividend payers returned 9.1% per year vs. a 7.5% annual return for an equal-weighted portfolio of S&P 500 companies.

Of course, past performance is no guarantee of future results. Dividend-paying stocks may very well lag non-dividend-paying stocks in the future. But one thing is certain: Putting dividend-paying stocks in a tax-advantaged account will almost certainly result in a better return than holding them in a taxable account, because you'll avoid the dividend reinvestment tax as your wealth compounds over time.

There are few free lunches in investing, but minimizing taxation is as close to "free money" as it gets.

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Jordan Wathen has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.



This article appears in: Personal Finance , Stocks
Referenced Symbols: PM , MCD , O , SWTSX , DPS


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