7 Things You May Not Know About Dividends

In a recent article, I dug into the pros and cons of dividend reinvestment. After the article was published, readers sent me a few emails with questions about other dividend-related topics. Since this topic turned out to be surprisingly popular, I’ve rounded up some of the most common questions here.

1) What do I need to watch out for with reinvested dividends and wash sales?

The key thing to keep in mind is that reinvesting dividends means you’re purchasing additional shares. That can complicate matters if you want to sell a position or engage in tax-loss harvesting in a taxable account. Under wash-sale rules, the IRS won’t allow you to claim a tax loss after making a sale if you’ve purchased the same or “substantially identical” security within 30 days before or after the sale. With careful timing, you could wait at least 30 days after a quarterly dividend payment before making a sale, and make sure to sell at least 30 days before the next dividend is paid. That may be more hassle than it’s worth, so it’s probably best not to reinvest dividends for any holdings that you contemplate selling in the near future.

2) If I reinvest dividends, will I end up with fractional shares that are difficult to sell?

If you elect to reinvest dividends, that means you’re purchasing small amounts that get added to your existing position in a stock or fund. As a result, you’ll probably end up with fractional shares, which are positions where you own part of a share instead of the full share. Most major brokerage platforms will allow you to sell fractional shares, but the process may be slightly more involved than selling a full share. You typically need to sell fractional shares as a market order rather than a limit order, and the fractional shares may take an additional day to liquidate after you’ve sold the full share.

3) How are dividends taxed?

For stocks and stock funds, the tax rate depends on whether the dividend is qualified or nonqualified (also known as ordinary). Dividends are considered qualified if you’ve held the stock or fund for more than 60 days out of the 121-day window that starts 60 days before the holding goes ex dividend and ends 60 days after that date. Qualified dividends are taxed at the lower capital gains rate (typically either 0% or 15% for most people) instead of as ordinary dividends. Dividends from holdings that don’t meet these holding requirements are considered nonqualified and are taxed as ordinary income.

Payments from bonds (or bond funds) are considered interest income and are typically taxed as ordinary income. Income from Treasury bonds is exempt from state and local taxes, and income from municipal bonds is usually exempt from federal taxes, as well as state and local taxes, depending on the location of the issuer.

4) Are reinvested dividends taxable?

Yes. As I mentioned in the previous article, dividends for holdings in taxable accounts are taxable whether you take them in cash or reinvest them. Reinvesting can make things more complicated from a tax perspective. If you reinvest dividends, you’ll need to add each dividend (the amount being used to buy more shares) to the holding’s cost basis. As a result, you could end up with many separate tax lots with different cost-basis levels. That can complicate matters when you eventually sell the stock since you’ll need to match up each sale with a specific tax lot.

5) Are stocks that pay dividends better?

If you ask a finance professor, the answer would be no. Money is fungible, after all, so whether you receive it in the form of income or capital appreciation doesn’t really matter. And the value of a company shouldn’t depend on whether it pays shareholders a dividend or not. This is part of the famous Modigliani–Miller theorem, which also states that a company’s value doesn’t depend on whether it finances its operations by selling equity or raising debt. However, behavioral finance researchers have also found that many investors prefer dividends because they perceive them as being more stable and predictable than capital gains. And as I discussed above, tax issues are another important consideration.

6) How do dividend-oriented strategies perform in a recession?

As I wrote about in a previous article, dividend stocks have historically held up relatively well during economic slowdowns. They’ve also provided a degree of downside protection during some—but not all—market drawdowns. However, funds that focus on stocks with the highest yields without incorporating quality screens can be more exposed to economic weakness. That’s because they tend to have more exposure to economically sensitive sectors, as well as companies that may not have the wherewithal to keep paying dividends during recessions.

7) Can I live off my portfolio’s dividends and interest income in retirement?

Some investors find this approach appealing. Dividends can create a steady stream of income similar to the regular paychecks most folks receive during their working years, and many investors like the idea of not dipping into their principal. However, it can be tough to create a portfolio that can generate enough yield to support an income-only approach, especially given the need to keep pace with inflation. On average, US stocks currently offer dividend yields of about 1.25%, although some dividend-oriented funds such as Schwab U.S. Dividend Equity ETF SCHD sport dividend yields of 3.9% or more. In many cases, relying solely on dividends and interest income to support retirement spending might mean you’d need to amass a larger portfolio than you would otherwise. By the same token, an income-focused approach means you would likely be underspending during retirement and might end up with a large portfolio balance after death. That might be appealing for retirees who have a strong interest in leaving a bequest behind, but the trade-off means lower spending while you’re still alive.