Why Corporate Executives Should Minimize Dividends in their Portfolios

OK, the somewhat provocative title aside, we are fans of dividends. Dividends are a fantastic source of income for many investor types providing a steady stream of income that is taxed at a lower rate than ordinary income (e.g. salary, bonus and interest.) This steady, fairly predictable and tax efficient income stream works great for working families in lower tax brackets and retirees. But, while the financial media and investment gurus often tout high dividends as an attractive characteristic, this generality is not always applicable to high earning corporate executives. Still it is common for clients to exaggerate the value of owning high dividend paying stocks at the expense of other important factors such as tax efficiency and long-term growth prospects. Frankly, if you are a high earning corporate executive you have no business generating a “bunch” of additional taxable income from dividends (or interest income for that matter) in your investment portfolio. Here is why…

Your W-2 income has you covered

First, you are generating a lot of cash flow from your salary, bonus and equity payouts. Already, you have significant taxable income (and tax expenses) flowing through your personal income statement. Even without producing additional taxable income from your investments, your income tax bill probably already makes you a little nauseous - but more on taxes in a minute.

As a corporate executive in the high earning phase of your career, you likely do not need the dividend income to finance your living expenses. A combination of salary, bonus and equity compensation is likely more than enough to cover these month to month expenses as well as your savings goals. Most likely, when you receive a dividend payment, your cash balance increases (earning a minimal return, if any) until you or your advisor rebalances and puts the cash back to work. Remember, one of the most important predictors of meeting your personal finance goals is the amount of time your savings are invested. So, while it may not seem significant, the drag on investment returns from holding too much cash - even if only temporarily - can have a real impact. Yes, you can solve this “cash drag” problem by setting up a Dividend Reinvestment Program (DRIP), but that still leaves you with other issues...

There is a Reason Companies Pay High Dividends

More importantly, companies that pay high dividends are returning cash to shareholders because it is the best use of their capital. This implies that the company lacks growth opportunities. By no means does this mean that the company’s stock is a poor investment, many times it is indicative of smart and disciplined management of capital allocation. However, if you are an investor with a long-term investment horizon - as many high earning corporate executives are - you have the ability to invest in companies with higher growth prospects and as a result a higher expected return. Of course, these companies tend to have a higher risk profile but, again, long-term investors have the ability to weather short and medium term volatility in exchange for a higher expected return. Now, one of our favorite topics: Taxes.

You do not need MORE taxable income

Finally, as a high earning corporate executive, taxes are already a big pain point. We say it a lot but we will say it again: paying more taxes than you need to is one of the biggest risks to meeting your financial goals. Dividends do provide a tax efficient income stream compared to interest and income generated from real estate, but the income is still taxable AND as a high earner you will most likely pay a higher tax rate on this income stream today than you will during future lower income years such as retirement.

So, how are dividends taxed? Remember, there are two types of dividends and you likely have a mix of both in your portfolio: Qualified and Ordinary. Qualified dividends are taxed at a preferential rate ranging from 0% - 23.8% based on your income (See Table Below). For corporate executives with taxable income above $553,850 and filing a joint tax return, qualified dividends will be taxed at 23.8% - the 3.8% Net Investment Income Tax is added to all investment income for Joint Filers with a Modified Adjusted Gross Income above $250,000. Ordinary Dividends (and interest) are taxed at the marginal tax rate which for a higher earner is significantly higher than the rate for Qualified Dividends. For example, a corporate executive with $500,000 of taxable income will pay a 38.8% tax rate (35% Marginal Rate + 3.8% Net Investment Income) on Ordinary Dividends and Interest Income (See Table Below).

The Takeaway

We are certainly not suggesting eliminating dividends from your portfolio because a well-diversified portfolio holds asset classes and securities such as value-oriented stocks, bonds, and sometimes real estate that generate taxable income. However, the goal is to reduce taxable investment income during your peak earning (and peak tax rate) years AND produce an investment return that matches your ability to take investment risk. An investment strategy that optimizes your portfolio to generate an appropriate investment return and minimizes taxable income by placing securities producing most investment return from capital appreciation (as opposed to dividends) in taxable accounts and any higher dividend/interest-yielding securities in tax-advantaged accounts (such as 401(k), IRA and Non-Qualified Deferred Compensation) will reduce your lifetime tax expenses and, as a result, accelerate your retirement.

Mark Chisenhall, CFA is the founder of Taurus Financial Planning, a wealth management firm specializing in helping high-earning corporate executives reduce taxes, optimize investments, and accelerate retirement. Check out other relevant posts that take a deeper dive into understanding tax topics such as income taxes and withholding, tax-advantaged accounts, and managing concentrated company stock positions. If you are interested in learning more about working with Taurus Financial Planning, you can schedule an introductory call here.

Qualified Dividend Tax Table

Ordinary Income Tax Table

This publication is for informational purposes only and is not intended as tax, accounting or legal advice or as an offer or solicitation of an offer to buy or sell or as an endorsement of any company security fund or other securities or non securities offering. This publication should not be relied upon as the sole factor in an investment making decision. Past performance is no indication of future results. Investment in securities involves significant risk and has the potential for partial or complete loss of funds invested. It should not be assumed that any recommendations made by the Author, in the future, will be profitable or equal the performance noted in this publication.