Author Topic: Dividend tax question  (Read 4145 times)

outtaheresoon

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Dividend tax question
« on: April 08, 2015, 12:43:39 PM »
So in the short period of time I have found this site I have been convinced to start investing in Vanguard dividend funds.  My question is how will I be taxed each year having dividends and hopefully fund appreciation each year - I do not plan on selling the funds for at least 5 years.

MDM

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Re: Dividend tax question
« Reply #1 on: April 08, 2015, 01:11:28 PM »
You'll pay tax on dividends and any capital gains incurred by the fund itself.  You don't pay anything on share price increase until you sell your shares.

See https://advisors.vanguard.com/VGApp/iip/site/advisor/investments/taxcenter and links therein for some fund-specific information.

skyrefuge

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Re: Dividend tax question
« Reply #2 on: April 08, 2015, 01:17:49 PM »
It depends a bit what you mean by "Vanguard dividend funds". Do you have a particular fund(s) in mind?

Any dividends distributed by a fund will be taxed at the appropriate dividend tax rate.

Any capital gains distributed by a fund (as a result of the fund selling underlying stocks) will be taxed at the appropriate capital gains rate.

Nearly all stock funds will distribute dividends. Index funds rarely distribute capital gains, while actively-managed funds frequently distribute capital gains.

Furthermore, when selling the fund, you will also pay tax on the gain in fund value between when you bought and when you sold.

If you're concerned about taxation, and in the accumulation stage, choosing a dividend-focused fund is an odd choice. Why would you prefer such a fund over a total-market index fund such a VTSAX?

Financial.Velociraptor

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Re: Dividend tax question
« Reply #3 on: April 08, 2015, 01:28:17 PM »
Dividends and nondividend distributions can get messy from a tax perspective.  First are qualified versus non-qualified dividends; qualified pay a lower rate.  Some dividends are tax exempt such as from municipal bonds (but a *small* portions is usually still subject to AMT.)  MLPs have built in gains, losses, exemptions, deductions, and even tax deferred return of capital.  Closed end funds often have a mix of all the above distribution types.  And any ETF can include pass throughs of short term and/or long term capital gains.  The (somewhat) good news is the issuer does the grunt work by putting the appropriate amount on the appropriate form (1099-xxx, k-1) and you just have to populate the boxes into the correct place on your tax software.  I use Taxact (free, online) and find it pretty intuitive for everything except for k-1 box 20z.

I always assume the worst case short term capital gains rate for making estimated payments.  I always end up over estimating but it beats underestimating and owing a 10% penalty.

outtaheresoon

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Re: Dividend tax question
« Reply #4 on: April 08, 2015, 01:28:33 PM »
It depends a bit what you mean by "Vanguard dividend funds". Do you have a particular fund(s) in mind?

Any dividends distributed by a fund will be taxed at the appropriate dividend tax rate.

Any capital gains distributed by a fund (as a result of the fund selling underlying stocks) will be taxed at the appropriate capital gains rate.

Nearly all stock funds will distribute dividends. Index funds rarely distribute capital gains, while actively-managed funds frequently distribute capital gains.

Furthermore, when selling the fund, you will also pay tax on the gain in fund value between when you bought and when you sold.

If you're concerned about taxation, and in the accumulation stage, choosing a dividend-focused fund is an odd choice. Why would you prefer such a fund over a total-market index fund such a VTSAX?

It may very well be an odd choice, since I am new to all this ;)  We are in the accumulation stage so I was thinking that getting the lower yet more reliable/predictable returns  would be the way to go.  Do you recommend putting money into stocks funds i.e VTSAX (we both max out our 401k's) and then once we hit our goal and are ready to retire we move out of the stock funds into dividend funds?  Really appreciate your input!!

skyrefuge

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Re: Dividend tax question
« Reply #5 on: April 08, 2015, 02:20:32 PM »
It may very well be an odd choice, since I am new to all this ;)  We are in the accumulation stage so I was thinking that getting the lower yet more reliable/predictable returns  would be the way to go.  Do you recommend putting money into stocks funds i.e VTSAX (we both max out our 401k's) and then once we hit our goal and are ready to retire we move out of the stock funds into dividend funds?  Really appreciate your input!!

First, it makes more sense to want "lower yet more reliable/predictable returns" in retirement than it does during the accumulation stage. When you're working, your income stream means that reliable/predictable returns from your investments are not necessary, and if they come at the cost of lower returns, then you'd be giving up something for not much in return (pun (?), uh, not intended?) When you're retired and your investments are providing your income, then reliable/predictable returns might be more comforting, though the research that led to the the 4% Safe Withdrawal Rate already takes broad stock market volatility into account and requires no special dividend-focus to work.

Second, there's no clear evidence that dividend-focused funds actually produce more reliable/predictable returns than dividend-agnostic funds. It sounds like a reasonable theory on the surface, but when you understand that a dividend payment causes the share-price to get chopped down, you'll see that dividends themselves don't add any reliability to total returns.

Here is a chart showing the jaggedness of the returns in 5 of Vanguard's dividend-focused funds compared to VTSAX (and to VTBLX, Vanguard's Total Bond Market Index, to show what "lower yet more reliable/predictable returns" actually look like). Good luck finding which one is VTSAX amongst all the similar squiggles!

The only way to get reliable, predictable returns in the stock market is to pick companies that you know will provide reliable and predictable returns, and that's really hard to do. Investing in bond funds is a much better way to add that stability to your returns.

So yeah, in my opinion, a total-market fund like VTSAX is a better choice in almost all cases. And while a dividend-focus makes a bit more sense in the retirement stage than the accumulation stage (since the drag of dividend taxation is more acceptable then), even during the retirement stage, VTSAX will serve you just as well if not better. Note that VTSAX's 1.84% dividend yield isn't much different than that from 3 of the 5 dividend-focused funds, so you'll still get dividends, for better or worse. But since it doesn't try to exclude the stocks that choose methods other than dividends to return value to shareholders, you'll also get lower expenses and much better diversification.

teen persuasion

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Re: Dividend tax question
« Reply #6 on: April 08, 2015, 04:55:09 PM »
It depends a bit what you mean by "Vanguard dividend funds". Do you have a particular fund(s) in mind?

Any dividends distributed by a fund will be taxed at the appropriate dividend tax rate.

Any capital gains distributed by a fund (as a result of the fund selling underlying stocks) will be taxed at the appropriate capital gains rate.

Nearly all stock funds will distribute dividends. Index funds rarely distribute capital gains, while actively-managed funds frequently distribute capital gains.

Furthermore, when selling the fund, you will also pay tax on the gain in fund value between when you bought and when you sold.

If you're concerned about taxation, and in the accumulation stage, choosing a dividend-focused fund is an odd choice. Why would you prefer such a fund over a total-market index fund such a VTSAX?

It may very well be an odd choice, since I am new to all this ;)  We are in the accumulation stage so I was thinking that getting the lower yet more reliable/predictable returns  would be the way to go.  Do you recommend putting money into stocks funds i.e VTSAX (we both max out our 401k's) and then once we hit our goal and are ready to retire we move out of the stock funds into dividend funds?  Really appreciate your input!!

Where do you have these funds?  Taxable accounts, tax-deferred, tax-free?  Your mention of 401k accounts makes me question whether you understand the tax differences.  Everyone has been answering for taxable accounts - if you are using 401Ks then they will either be tax free (if Roth) or taxed as ordinary income (if non-Roth).

outtaheresoon

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Re: Dividend tax question
« Reply #7 on: April 08, 2015, 07:41:07 PM »
It may very well be an odd choice, since I am new to all this ;)  We are in the accumulation stage so I was thinking that getting the lower yet more reliable/predictable returns  would be the way to go.  Do you recommend putting money into stocks funds i.e VTSAX (we both max out our 401k's) and then once we hit our goal and are ready to retire we move out of the stock funds into dividend funds?  Really appreciate your input!!

First, it makes more sense to want "lower yet more reliable/predictable returns" in retirement than it does during the accumulation stage. When you're working, your income stream means that reliable/predictable returns from your investments are not necessary, and if they come at the cost of lower returns, then you'd be giving up something for not much in return (pun (?), uh, not intended?) When you're retired and your investments are providing your income, then reliable/predictable returns might be more comforting, though the research that led to the the 4% Safe Withdrawal Rate already takes broad stock market volatility into account and requires no special dividend-focus to work.

Second, there's no clear evidence that dividend-focused funds actually produce more reliable/predictable returns than dividend-agnostic funds. It sounds like a reasonable theory on the surface, but when you understand that a dividend payment causes the share-price to get chopped down, you'll see that dividends themselves don't add any reliability to total returns.

Here is a chart showing the jaggedness of the returns in 5 of Vanguard's dividend-focused funds compared to VTSAX (and to VTBLX, Vanguard's Total Bond Market Index, to show what "lower yet more reliable/predictable returns" actually look like). Good luck finding which one is VTSAX amongst all the similar squiggles!

The only way to get reliable, predictable returns in the stock market is to pick companies that you know will provide reliable and predictable returns, and that's really hard to do. Investing in bond funds is a much better way to add that stability to your returns.

So yeah, in my opinion, a total-market fund like VTSAX is a better choice in almost all cases. And while a dividend-focus makes a bit more sense in the retirement stage than the accumulation stage (since the drag of dividend taxation is more acceptable then), even during the retirement stage, VTSAX will serve you just as well if not better. Note that VTSAX's 1.84% dividend yield isn't much different than that from 3 of the 5 dividend-focused funds, so you'll still get dividends, for better or worse. But since it doesn't try to exclude the stocks that choose methods other than dividends to return value to shareholders, you'll also get lower expenses and much better diversification.

Great information!  Thanks!

outtaheresoon

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Re: Dividend tax question
« Reply #8 on: April 08, 2015, 07:46:42 PM »
It depends a bit what you mean by "Vanguard dividend funds". Do you have a particular fund(s) in mind?

Any dividends distributed by a fund will be taxed at the appropriate dividend tax rate.

Any capital gains distributed by a fund (as a result of the fund selling underlying stocks) will be taxed at the appropriate capital gains

Nearly all stock funds will distribute dividends. Index funds rarely distribute capital gains, while actively-managed funds frequently distribute capital gains.

Furthermore, when selling the fund, you will also pay tax on the gain in fund value between when you bought and when you sold.

If you're concerned about taxation, and in the accumulation stage, choosing a dividend-focused fund is an odd choice. Why would you prefer such a fund over a total-market index fund such a VTSAX?

It may very well be an odd choice, since I am new to all this ;)  We are in the accumulation stage so I was thinking that getting the lower yet more reliable/predictable returns  would be the way to go.  Do you recommend putting money into stocks funds i.e VTSAX (we both max out our 401k's) and then once we hit our goal and are ready to retire we move out of the stock funds into dividend funds?  Really appreciate your input!!

Where do you have these funds?  Taxable accounts, tax-deferred, tax-free?  Your mention of 401k accounts makes me question whether you understand the tax differences.  Everyone has been answering for taxable accounts - if you are using 401Ks then they will either be tax free (if Roth) or taxed as ordinary income (if non-Roth).

Should have been more clear....these funds would be outside/in addition to our 401k's.  We both max out our 401k's and have additional cash to invest.