The Dividend Drag Dilemma

Rhea Zhou, Senior Analyst of Index Product Development at Nasdaq

Many ETFs make dividend distributions, which are typically considered taxable events in taxable brokerage accounts. Even if an investor chooses to reinvest their dividends, the investor still owes taxes today. This can cause a ‘drag’ on long-term total returns. In today’s post, we explore how taxes on reinvested distributions can impact the overall investor experience.

Reinvesting dividends is important

Reinvesting dividends is important, especially for investors who want to achieve total return.

Chart 1 shows the difference in keeping dividends (gray line) vs. reinvesting dividends (blue line) for U.S. equities over the last 20+ years. For example, note that reinvesting dividends has contributed to an additional 197% cumulative return over this period, thanks to the benefits of compounding.

Chart 1: Price Return vs. Total Return for U.S. Equities

The difference between total return and price return depends on the distribution (or the ‘yield’) of the underlying investment. In fact, we can approximate the yield by taking the difference between total return and price return. In general, the distribution yield can vary across asset classes (Chart 2).

Chart 2: Distribution Yield Across Assets

Income-oriented assets tend to have higher distribution rates, and as such, the importance of reinvesting dividends is even higher. Note that the longer the investment time horizon, the greater the impact of reinvesting dividends is due to compounding.

But reinvesting can sometimes cause taxes…

However, in U.S. taxable accounts, dividends are treated as income. So, once an investor receives a dividend, she must pay taxes even if the distribution is immediately reinvested (Chart 3).

Chart 3: Taxes are Owed Today on Dividends

This causes a potential ‘drag’ on performance since the total dividend reinvested is technically taxed.

For example, Chart 4 below shows the cumulative price return and total return of AGG (U.S. fixed income). Similar to Chart 1, we see the positive benefit of reinvesting dividends to achieve total return (blue line vs. gray line in Chart 4). However, assuming an investor pays taxes on those reinvested distributions, realized performance may look closer to the yellow line.

Chart 4: U.S. Fixed Income Post-Tax Total Return

And, as we will see later on, the difference between the pre-tax and post-tax total return will look different across assets.

Impact of taxes varies across assets

We can quantify the potential impact of taxes by comparing the annualized returns with and without taxes on reinvested dividends.

Ignoring any potential capital gains taxes, post-tax total return can generally be estimated as:

Price Return + Yield x (1-Tax Rate)

For example, assuming:

• Annual Price Return = 1%
• Annual Dividend Yield = 2%
• Tax Rate on distributions = 37%

We would estimate the hypothetical total return as 3% (price return + yield). However, assuming an investor pays taxes on the distribution, the post-tax total return might be closer to 2.26% (price return + yield x (1-tax)). This suggests that the tag drag is around 0.74% (2.26% vs. 3%).

Chart 5 below plots the price return, pre-tax total return, and estimated post-tax total return for a sample of U.S. listed ETFs over the full-year 2024.

Chart 5: Pre-Tax vs. Post-Tax Total Return Across Assets

Note that the blue bar represents the hypothetical total return (assuming no taxes are paid on reinvested distributions). However, the yellow line represents the estimated after-tax total return (assuming a fixed tax rate on reinvested distributions). The difference between the blue bar and the yellow line represents the ‘drag’ caused by taxes.

We summarize the drag in Chart 6 below across each fund in our sample. Note that tax drag (represented in basis points) is generally higher for higher-yielding assets.

Chart 6: Tax Drag Across Assets

For example, we estimate tax drag of around 32bps for SPY (U.S. large cap equities), compared to over 130bps for AGG (U.S. fixed income). As we saw before, this could be costly for long-term buy-and-hold investors who systematically reinvest dividends.

However, what if there was a way to potentially avoid this drag in a taxable account? Assuming there was a way to avoid this drag, we could also consider the green dots as potential ‘tax alpha’, or the excess return above the taxed total return. We’ll save more on that topic for our next post.

Conclusion

Overall, reinvesting dividends can be an important driver of achieving total return. However, for a U.S. investor using a taxable brokerage account, receiving distributions represents a taxable event. Even if an investor chooses to reinvest dividend distributions, she must still pay income taxes today. This results in a drag on long-term total returns, which can be costly depending on the asset.

What if there was a way to replicate total returns without having to reinvest dividends? Could we avoid this friction to improve the investor experience? Stay tuned for our next report in which we will explore a potential solution to this problem. 

Disclaimer:

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