Dividends, Taxes and SWR

[Sir_Lurksalot]

I'm going to throw this out for fun. Hopefully we can all agree that the current dividend yield for the SP500 is near historical lows because of the dividend taxation that was created in 1986 rather than because of the economy being particularly poor for the last 18 years.

If the dividend tax were somehow eliminated in the future, one might think that the dividend yield would grow. I'll suggest that it could return to the 4% historical average. Is it surprising that number seems to match a "100%" SWR? It certainly makes sense to me that if you held 100% in stocks and could live fully on the dividends (tax free in this example) that you have it made.

I believe that these 2 numbers are not similar just by coincidence. I'll further state that I hope anyone who is interested in gaining an accurate gauge for a SWR would push elected officials to eliminate taxation of dividends to increase the correlation between SWR and dividend yield. Ok, I just want to have a SWR tax free.

Lurksalot

 

[sgeeeee]

. . .I believe that these 2 numbers are not similar just by coincidence.  . . .

Actually, I think it is just coincidence. First, remember that SWR is not computed based on average return but based on worst case 30 year portfolio survival. Also, SWR includes the effects of inflation. And finally, the 4% number comes not from a 100% stock allocation but for stock allocations as low as about 50% to as high as about 75%.

 

[John Galt]

I agree. Just coincidence.

John Galt

 

[hocus]

There has been a good bit of exploration of the connection between dividends and SWRs at the SWR Research Group board. Here's a thread that was started by our own UncleMick and which is titled "The Dividend Goose."

Wait a minute. That doesn't sound right somehow. Give me a minute to follow the link and check that.

http://www.nofeeboards.com/boards/viewtopic.php?t=2899

Oh, yes, of course. It's titled "The Dividend Duck."

 

[Sir_Lurksalot]

Actually, I think it is just coincidence. First, remember that SWR is not computed based on average return but based on worst case 30 year portfolio survival. Also, SWR includes the effects of inflation. And finally, the 4% number comes not from a 100% stock allocation but for stock allocations as low as about 50% to as high as about 75%.

hmm. yes, i wasn't thinking about the worst case vs. average at the moment i posted. but this alone does not make it mere coincidence (which it may very well be). it COULD be that in the worst of times, if you do not spend more than the earnings your stocks throw off (dividends) then you survive.

while this hypothesis does not directly account for inflation, i think it's built in. perhaps i'm being naive - since holding stocks you are owning the producers that are raising prices.

and i had thought about the 75/25% allocation vs. my proposed 100% for simplicity. but again, it could be just less obvious. i mean, those same companies earnings are financing your money either way. i know bonds smooth out the volatility and all, but you can't escape the fact that the government and its debts are supported by the earnings of its companies. if our stocks were to become truly worthless and unable to throw off cash - so would our govt's debt.

i believe that living on dividends obviously gives you a SWR. but not necessarily the highest SWR. if you look for a 100% SWR it's going to be pretty close. i'd have expected it to be a little higher, in that you should be able to canabalize some of your shares each year. and maybe this can only account for a fractional percentage each year or else when times get tough you fail.

firecalc is cool because it helps you see increased rates that MAY be possible in the future. we all know that past performance is no guarantee for future performance. i'm not trying to draw anyone into an argument on any of these points. just my thoughts.

Lurksalot

 

[hocus]

It COULD be that in the worst of times, if you do not spend more than the earnings your stocks throw off (dividends) then you survive.

The Trinity study (a conventional methodology study) showed that the SWR is a good bit lower than the annualized real return. The reason why it is lower is that, if you get a particularly bad returns sequence, you need to sell stocks in the early years of your retirement to cover your living expenses. Once you sell those stocks, you lose the benefit of future price appreciation on them.

Say that the annualized real return over 30 years is 7 percent. If you got a return of 7 percent each year, you would be able to take out 7 percent each year. But with stocks you don't get an even return. The worst returns sequence is one in which you have lots of down years early in your retirement. That requires you to sell stocks at low prices, and that kills you in the long-term.

The argument for high-dividend stocks (as I understand things) is that there is a sense in which they are less volatile than low-dividend stocks. The price of the stocks might head downward in a bear market. But the dividend might hold steady. So you might not need to sell as many stocks in the early years of a poor returns sequence. Stability of return increases SWRs, all else being equal.

We have not reached definitive conclusions re the dividends aspects of SWR analysis. But JWR1945 has done a lot of work in this area. I think it is fair to say that he sees a lot of merit to strategies that take the dividend payout ratio of stocks into account.

The above is a layman's description of the dividends discussions now going on at the SWR board. Those with an interest in knowing the ins and outs of the numbers need to check out the posts that have been put forward by JWR1945 and others because a lot of the numbers stuff is beyond me. My understanding of the dividends stuff is not particularly strong, but there are others who have explored it in a good bit of detail. This is the #1 issue being explored at the SWR board today.

 

[Michael]

Hopefully we can all agree that the current dividend yield for the SP500 is near historical lows because of the dividend taxation that was created in 1986 rather than because of the economy being particularly poor for the last 18 years.

I agree that the economy has not been poor for the last 18 years, but I don't think the 1986 tax change is solely responsible for today's low dividends. I think the dividend yield is low mostly because people bid prices up to the point where yield fell.

 

[wabmester]

Michael's right. The dividends haven't gone down, just the P/D has gone up.

Besides, dividends used to be taxed at the ordinary income rate before 1986. So dividend taxes were even higher.

 

[Sir_Lurksalot]

Michael's right. The dividends haven't gone down, just the P/D has gone up.

Besides, dividends used to be taxed at the ordinary income rate before 1986. So dividend taxes were even higher.

Tax code is obviously complex, and I'm not going to bother trying to prove this. But the taxation of dividends is higher than it was pre-1986. If you say it was taxed at regular income before, that may be true. But if that were true, than the corporation was not taxed on it before it paid it. That's the double taxation part that people are complaining about. Companies are paying income tax on it, then you are paying dividend tax on it. You are correct stocks have been bid up. What you've missed is that they have been bid up because there is income that is no longer paid out. The money stays in the company and drives the share prices up. Because the "double taxation" issue companies found that it was no longer more beneficial for their owners to pay out earnings through dividends. It saves the owners money if they use the money to grow and the owner captures the capital gains and pays tax on THAT which is only getting taxed once. I'd love to remove the tax on dividends and make it more beneficial to pay dividends than trying to grow. I believe that the lack of dividends is leading to increased speculation and volatility - all of which can hurt ER'ers.

Lurksalot

 

[Michael]

I'd love to remove the tax on dividends...

I would too. All taxes should be immediately and permanently removed from all dividends, interest, and capital gains. The current system punishes people for saving and investing for their future, and distorts the free market system.

 

[farmerEd]

>>I would too. All taxes should be immediately and permanently removed from all dividends, interest, and capital gains. The current system punishes people for saving and investing for their future, and distorts the free market system.

I don't know...I am one of the people that would benefit from such a change in tax code. I am retired and I live off my investments...but, I don't know exactly how I feel about giving "rich" people a free ride, i.e. almost all their earnings are tax-free, and "punishing" working stiffs.

Why is it that the question is always framed in terms of "punishing" those who saving and investing? Are not people who live of their paychecks then being "punished" for working?

Its not hard to imagine a very-small and very wealthly group of people, living completely off of the interest and dividends of their investments, and having that pass from one generation to another (i.e. rockefellers, kennedys etc) and the children, grandchildren, great-grandchildren etc live their entire lives w/out paying any taxes....and elsewhere, some joe schmo who is busting his but all day at some factory or office is having 20-30-40% taking out of his check everyday?

This is not intended as a class warfare type of statement, but besides me personally benefitting from a tax exemption on investment income, I am not sure why it is a god idea to the population in general?

 

[Cut-Throat]

Farmer Ed,

Very well said! - I would be in favor of a Consumption Tax like Europe's VAT. With maybe an exemption on the first 20K per year of income spent.

This would actually allow the country to collect taxes on illegal funds (e.g. Drug Dealers and Bank Robbers)

 

[John Galt]

I agree with Cut_Throat (good post by Farmer Ed).

I pay myself dividends out of my tiny holding company.
The company is working down an NOL from previous years and I can control my income so that I pay no
federal income taxes. But, if my corp. was paying at
the corporate level, being denied a deduction for
dividends paid, and then I was getting whacked again
upon taking the money out.........yeah, there is
something wrong with that picture.

John Galt

 

[wabmester]

I believe the double taxation on dividends has been in effect since the turn of the last century.

farmerEd is right that removing the tax would primarily benefit the rich. In fact, it's been postulated that low taxes and laisez faire policies were at least partly responsible for the Great Depression. The gap between rich and poor was HUGE back then.

One of the measures introduced by FDR that brought us out of the depression was a huge redistribution of wealth by raising the top tax rate to something like 90%! I suspect we'll be doing that again sometime....

 

[retire@40]

I don't know...I am one of the people that would benefit from such a change in tax code. I am retired and I live off my investments...but, I don't know exactly how I feel about giving "rich" people a free ride, i.e. almost all their earnings are tax-free, and "punishing" working stiffs.

Rich people ALREADY get a free ride. For example, they can invest all their money in tax-free funds and not pay any tax.

Removing taxes on interest, dividends, and capital gains would help the not-so-rich-guy get rich by saving and encourage EVERYONE to save.

 

[retire@40]

Farmer Ed,

Very well said! - I would be in favor of a Consumption Tax like Europe's VAT.  With maybe an exemption on the first 20K per year of income spent.

This would actually allow the country to collect taxes on illegal funds (e.g. Drug Dealers and Bank Robbers)

How would the VAT allow the country to collect taxes on illegal funds?

The current tax code already says that illegal income is subject to tax.

 

[retire@40]

I pay myself dividends out of my tiny holding company.
The company is working down an NOL from previous years and I can control my income so that I pay no
federal income taxes.  But, if my corp. was paying at
the corporate level, being denied a deduction for
dividends paid, and then I was getting whacked again
upon taking the money out.........yeah, there is
something wrong with that picture.

If you're worried about double taxation, why didn't you set up as an S-corp instead of a C-corp? There's no double taxation for S-corps.

 

[farmerEd]

How would the VAT allow the country to collect taxes on illegal funds?

The current tax code already says that illegal income is subject to tax.

The theory is, that even if you got the money illegally, when you spend it on something, you'd have to pay the tax "at the register".

 

[farmerEd]

Rich people ALREADY get a free ride. For example, they can invest all their money in tax-free funds and not pay any tax.

Removing taxes on interest, dividends, and capital gains would help the not-so-rich-guy get rich by saving and encourage EVERYONE to save.

But then again, the not-so-rich guy can already use those same tax-free funds too, can't s/he?

 

[retire@40]

The theory is, that even if you got the money illegally, when you spend it on something, you'd have to pay the tax "at the register".

Sure, in theory.  Do you know the black market that would exist to avoid the consumption tax (as it does in Europe) if there was no requirement to account for your income (no tax returns required)?

A lot of illegal money would be spent on non-register items like electonics sold from a truck on the side of a road.

 

[retire@40]

Rich people ALREADY get a free ride.  For example, they can invest all their money in tax-free funds and not pay any tax.

Removing taxes on interest, dividends, and capital gains would help the not-so-rich-guy get rich by saving and encourage EVERYONE to save.

But then again, the not-so-rich guy can already use those same tax-free funds too, can't s/he?

Anyone can use tax-free funds, but it makes a lot of sense for someone in a high tax bracket to use those funds and almost no sense for someone in a low tax bracket.

 

[wabmester]

Three things happen when you lower taxes:

1) people will spend more, especially those with lower and middle income
2) the wealthy will save/invest more
3) tax revenues will decrease, so the govt will spend less

In the short-term (1) is good for the economy, (2) is good for the stock market, but eventually (3) will bite you, unemployment will rise, the economy will slow, stocks will crash, and taxes will go back up in a big way to make up for the short-fall.

 

[Austin_Explorer]

3) tax revenues will decrease, so the govt will spend less

Actually, it's tax revenues will decrease, so the govt will write more IOU's and pass the bill on to the next generation. When has the government ever REALLY cut spending. Cut the increases? Sure. Cut overall spending? Not sure I've ever seen it.

 

[sgeeeee]

As long as we continue deficit spending, elimination of taxes on dividends amounts to a transfer of taxation away from the wealthy of today and onto the poor and middle class of tomorrow.

The bills have to be paid eventually, and if the wealthy, who would receive the lion's share of the tax break, aren't paying, then everyone else is.

http://www.spinsanity.org/post.html?2003_01_26_archive.html


There are at least two forms of income that are significant to the wealthy and much less so (or completely insignificant) to the poor and middle class -- inheritance and dividends. Reducing these taxes while deficit spending is a tax transfer from rich to poor.

If we need to transfer tax burden from the rich to the poor (something that I don't believe would be a very popular position) we should be up-front about it, and pay as we go rather than burden the poor of the future without their say or knowledge.

 

[charlie]

Hey wab,

I agree with your points 1 & 2, but I think JFK proved
that tax revenues actually go up eventually because
of the stimulus provided by 1 & 2. I think it is called
"supply side" economics. The trouble comes when
spending is not held in check. But what do I know ?
I majored in EE not Eco.

Cheers,

Charlie