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If you own a dividend-paying stock, you get to look forward to some extra money in your brokerage account every quarter. If you’re the type to spend your dividend payouts, companies make it easy for you to receive your dividends in cash.
For example, some dividend-paying companies, like Exxon (NYSE: XOM), offer shareholders the convenient option of having their dividends deposited directly into a checking account — or even mailed as a physical check. This saves shareholders the hassle of having to initiate electronic transfers out of their brokerage accounts every time a dividend is paid.
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However, not all shareholders want to spend their dividends. Many others take advantage of their broker’s dividend reinvestment programs (DRIPs) and use their dividends to buy more shares of the same dividend-paying company’s stock.
When the next quarter rolls around, the shares acquired by reinvesting dividends earned in the previous quarter will also pay dividends. If these dividends are reinvested once again, a compounding effect takes hold. Over time, investors will own an ever-increasing number of shares that collectively generate a larger and larger dividend payout.
Clearly, it’s difficult to deny that DRIPs are a pretty great option for investors. However, reinvesting dividends isn’t always the most optimal solution for long-term, buy-and-hold investors who want to maximize the effects of compound interest.
Dividends create tax drag
The reason? Taxes.
More specifically, it’s because all dividends are taxable, regardless of what you do with them. Unfortunately, that means that Uncle Sam will want his cut, even if you DRIP every last dime and don’t spend a penny of your dividend income.
If this happens to be you (and you forget to set a portion of your dividends aside for taxes), you’ll still have to somehow come up with the cash for the IRS on Tax Day. On the other hand, if you choose to use some of your dividends to meet your tax liability, you’ll reduce the amount you’ll be able to reinvest and dampen the compounding effect — hence “tax drag”. Suffice to say, neither scenario sounds ideal.
There are several exceptions, however. Namely, you can avoid racking up a tax bill if you hold your dividend-paying stocks in tax-deferred or tax-exempt accounts, like a traditional 401(k), Roth IRA, or HSA.
Meanwhile, those holding dividend-paying stock in taxable brokerage accounts may be able to avoid taxation if they receive qualified dividends and meet certain income thresholds. In 2022, single taxpayers with under $41,675 in taxable income are eligible for a 0% tax rate on their qualified dividends. This number rises to $83,350 for married taxpayers filing jointly and $55,800 for heads of households.
However, other than these specific scenarios, there’s really no way around it — if you receive dividends, expect to see some of it go to the U.S. Treasury.
Buybacks are better for buy-and-hold investors
If dividends aren’t the most tax-optimal solution for shareholders who want to be long-term part-owners of a company, then what’s the solution? How can profitable companies distribute cash to shareholders without creating tax liabilities for owners?
Enter buybacks. Also known as share repurchases, buybacks and (reinvested) dividends are essentially opposite sides of the same coin. After all, both are strategies a company can use to return money to its owners in a way that increases their stake in the company.
Specifically, while reinvested dividends are cash payments to shareholders who choose to funnel their dividends into acquisitions of more company stock, money earmarked for buybacks is used by a company to repurchase its own shares on the open market.
Repurchased shares are then retired, lowering the total number of shares outstanding and increasing the ownership stake of each remaining shareholder. And when buybacks occur repeatedly, shares outstanding decline exponentially, causing shareholders’ stakes in the company to rise exponentially — once again creating a compounding effect.
In a way, it’s as if the company DRIPs for you behind the scenes. But because you were never personally handed the cash to reinvest, you don’t owe any income tax — since there is no dividend income to speak of.
Of course, taxes will still be due once you decide to sell your stock, so the tax liability is deferred (like it is in a traditional IRA), rather than eliminated. Nonetheless, buybacks avoid the tax drag that plagues DRIPs, boost the compounding effect experienced during the holding period, and represent a tax-efficient method of boosting a shareholder’s stake in that company.
In short, if you need money to spend as income, dividends may be a good idea. However, if you’re looking to buy-and-hold and reinvest your dividends for the long-term, buybacks may be better for you, since they’re more tax-efficient. Even so, everyone’s priorities are different, and tax optimization is just one of many important considerations a diligent investor should make.
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Fool contributor Ryan Sze holds no financial position in any of the companies mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
