Over the past year, I’ve seen quite a few articles arguing that dividend investing is a bad way to invest. The premise is that self-created dividends (i.e., selling a few shares of your holdings now and then and on your own terms) are superior to “mandatory” dividends received from a company. And for tax purposes, the articles aren’t wrong. Mandatory dividends are taxed on the whole amount. Self created dividends on the other hand, are taxed only on the capital gains of the shares that you’ve sold.
For example. . . .
Let’s say you receive a $2,000 dividend from Company X and you have to pay a 15% tax of $300. That leaves you with $1,700 after taxes.
But let’s say instead, that Company X didn’t pay dividends. So you decide to sell a few shares of Company X for a self created dividend of $2,000. And let’s say you make a profit of $500 (because you originally bought those shares for $1,500). Then you’ll pay taxes on only the $500 profit (capital gain) and not the entire $2,000. And assuming that your tax rate is the long term capital gains tax rate of 15%, you’ll pay just $75, leaving yourself with $1,925 after taxes. That’s more than the $1,700 you would’ve gotten from the “mandatory” dividend.
But this example assumes that you know what you’re doing.
Despite what the articles say, picking stocks that ensure consistent capital gains is not easy. And knowing when to sell a few shares versus holding them for further growth is even harder. It’s not as simple as just buying shares in a well known company and selling a few of those shares each month. For all we know, those shares could already be overvalued. And it may take years before your shares gain enough value to create your own dividend.
Moreover, creating your own dividend is not passive income.
Analyzing the market so that you can pick stocks and time your self created dividends is not early retirement. It’s work.
Dividend investing on the other hand is truly passive. Every month I put money into VOO like clockwork. I don’t think about how much to put in or when to put it in, I just drop a set amount and that’s it. And every three months, I receive a dividend. If I were lazier, I could even set up automatic investing.
Finally, self created dividends make it harder to diversify.
Unless you’re buying an index of non-dividend paying companies, you’re likely buying stocks in individual companies. That means you’re probably not diversifying as much as you should. And that means more concentrated risk in fewer companies. If these companies ever go bankrupt, you just might go bankrupt as well.
Dividend investing may give you the same problem if you invest in individual companies that pay dividends. That’s why I avoid individual stocks altogether and stick with dividend paying index funds that hold hundreds of companies.
So there you have it. As much as I love capital appreciation and lower taxes, dividend income is still my holy grail to early retirement. But hey, to each their own.