Dividend Basics

Hello, Marc.

Thank you for the great information you provide. I am learning every day and find that there are “basics” I don’t understand about dividends, including…

How do I know whether a dividend is taxable or tax-deferred?

When should I reinvest dividends or have them placed in my cash account?

Looking forward to the next Mailbag where you answer questions.

All the best. – Mary

Dividends are usually taxable.

Most companies pay qualified dividends, which are taxed at 15% for most investors and up to 23.8% for high-income earners.

If a company’s dividends are not qualified, it usually has information about the tax status on its investor relations website.

Some real estate investment trusts’ dividends are not qualified and are taxed at your ordinary income tax rate, but investors can deduct 20% off the dividend. In other words, if you received $100 in dividends, you’d pay tax on $80.

Companies whose dividends are tax-deferred are usually partnerships, and their names will have the word “partnership” or “partners” or include “LP” for limited partnership.

I recommend reinvesting all dividends unless you need the cash now. The more you reinvest now, the greater your wealth will compound and the more income it will generate later. If you need only some of the cash you’re earning from dividends, reinvest what you don’t need today.

Hi, Marc.

I am a Member of The Chairman’s Circle and have a question for you related to my retirement goal.

I have a $500,000 traditional IRA and will be looking to retire in a couple of years. My goal is to live off income generated by the portfolio and not touch the principal. I’m looking to generate a 6% to 7% minimum annual return. I thought The Oxford Income Letter portfolios would be a good fit.

Is this return possible? If it is, where would you recommend I start?

Thanks! – Bob S.

When you say “a couple of years,” if you literally mean two years, then 6% to 7% will be tough to achieve unless you’re invested in the High Yield Portfolio. Do keep in mind that many of those high-yielders come with increased risk.

If you have a longer time frame, then it should be possible. If your portfolio has a yield of 4% that grows its dividend by 8% per year and you’re reinvesting the dividend – assuming the stock’s performance is in line with the stock market’s historical average – you should be at 6% in five years. If you’re not reinvesting the dividend, it will take you just over six years.

Of course, the longer you’re reinvested, the more income you’ll earn when you stop dividend reinvestment and collect the cash.

Higher or lower starting yields and dividend growth rates will affect the final numbers as well.

The goal of the Instant Income Portfolio is to generate 11% yields within 10 years, and the goal of the Compound Income Portfolio is to generate 12% average annual total returns over 10 years with dividends reinvested.

Any of the stocks in the portfolios rated “Buy” can be bought. Each month, on the second Thursday, I publish my Top 3 column that details three stocks that are a good starting point for where to consider putting money to work.

What is the difference between the Instant Income Portfolio and the Compound Income Portfolio? Are they mostly the same stocks? What would have me invest in one versus the other? I assume the High Yield Portfolio gives a higher return with more risk.

In the portfolios, you say some stocks are better for tax-deferred accounts and others for taxable accounts. If they all produce dividends, what difference does it make aside from a personal choice of whether you want to defer the taxes or not? What are the issues?

Thank you. – Marilyn

I mentioned the goals of the Instant Income Portfolio and the Compound Income Portfolio in the answer to the question above. The Instant Income Portfolio is for investors collecting the dividend today. The Compound Income Portfolio is for investors who are reinvesting the dividends.

Any stock that qualifies for the Instant Income Portfolio will automatically qualify for the Compound Income Portfolio, but not necessarily the other way around.

There are times when I recommend a stock for the Compound Income Portfolio only, but then I’ll add it to the Instant Income Portfolio if an increased yield or growth rate qualifies it.

And yes, the High Yield Portfolio comes with more risk.

You’re also right that it’s each person’s choice as to whether they want to defer the taxes. Each recommendation is made with the assumption that the investor wants to be as tax-efficient as possible. You’re free to ignore the suggestion as to which type of account to keep it in.

The one caveat is if you have a lot of money invested in master limited partnerships (MLPs) that could generate unrelated business taxable income (UBTI) as part of the MLPs’ distributions.

If that’s the case, you are definitely better off holding the MLPs in a taxable account because if they’re held in a tax-deferred account, you could be on the hook for taxes and penalties if UBTI is greater than $1,000.

As I always suggest when it comes to taxes, speak with a tax professional who can offer advice based on your individual situation.

Hoping your longs go up and your shorts go down,

Marc