Stock Buybacks vs. Dividends: Which Is More Tax Efficient? | personal finance

(Ryan Wed)

If you own a stock that pays dividends, you can expect some extra money in your brokerage account each quarter. If you’re the type to spend your dividend payments, companies make it easy for you to receive your dividends in cash.

For example, some companies that pay dividends, such as Exxon (New York Stock Exchange: XOM), offers shareholders the convenient option of having their dividends directly deposited into a checking account, or even mailed as a physical check. This saves shareholders the hassle of having to initiate wire transfers from their brokerage accounts each time a dividend is paid.

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However, not all shareholders want to spend their dividends. Many others take advantage of their brokers. dividend reinvestment programs (DRIP) and use their dividends to buy more shares of the same company paying dividends.

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When the next quarter rolls around, shares purchased by reinvesting dividends earned in the previous quarter will be what’s more pay dividends. If these dividends are reinvested once again, a compound effect occurs. Over time, investors will own an ever-increasing number of shares, which together will generate an ever-increasing dividend payment.

Clearly, it’s hard to deny that DRIPs are a great option for investors. However, dividend reinvestment is not always the most optimal solution for long-term buy-and-hold investors who want to maximize the effects of compounding.

Dividends create fiscal drag

More specifically, it’s because all dividends are taxable, regardless of what you do with them. Unfortunately, that means Uncle Sam will want his share, even if he DROPS every penny and doesn’t spend a dime of his dividend income.

If this is the case for you (and you forget to set aside a portion of your dividends for taxes), you’ll still need to raise 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 will reduce the amount you can reinvest and cushion the compounding effect, thus the “tax brake.” Suffice to say, neither scenario sounds ideal.

However, there are several exceptions. That is, you can avoid racking up a tax bill by keeping your dividend-paying stock in tax-deferred or tax-exempt accounts, like a traditional 401(k), Roth IRAor HSA.

Meanwhile, those who hold dividend-paying stock in taxable brokerage accounts can avoid taxes if they receive qualified dividends and meet certain income thresholds. In 2022, single filers with less than $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 household.

Other than these specific scenarios, though, there’s really no way around it: if you receive dividends, expect to see some of it go to the US Treasury.

Buybacks are better for investors who buy and hold

If dividends are not the most tax-optimal solution for shareholders who want to co-own a company for the long term, what is the solution? How can profitable companies distribute cash to shareholders without creating tax liabilities for owners?

Enter buybacks. Also know as share repurchase, buybacks, and (reinvested) dividends are essentially opposite sides of the same coin. After all, both are strategies a business can use to return money to its owners in a way that increases their stake in the business.

Specifically, while reinvested dividends are cash payments to shareholders who choose to funnel their dividends into purchasing more shares of the company, a company uses the money earmarked for buybacks to repurchase its shares. own self shares on the open market.

The repurchased shares are then retired, reducing the total number of shares outstanding and increasing the ownership interest of each remaining shareholder. And when buybacks happen repeatedly, shares outstanding decline exponentially, causing shareholder ownership of the company to rise exponentially, once again creating a compound effect.

In a way, it’s like the company DRIP for you behind the scenes. But since you never were personally handed over the cash to reinvest, you do not owe any income tax, since there is is there is no dividend income to speak of.

Of course, taxes will still be due once you decide to sell your shares, so the tax liability is deferred (as in a traditional IRA), rather than eliminated. However, buybacks avoid the tax burden that affects DRIPs, increase the compounding effect experienced during the holding period, and represent a tax-efficient method of increasing a shareholder’s interest in that company.

In short, if you need money to spend as income, dividends may be a good idea. However, if you are looking to buy and hold and reinvest your dividends for the long term, buybacks may be better for you as they are more tax efficient. Still, everyone’s priorities are different, and tax optimization is just one of many important considerations for a diligent investor.

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dumb taxpayer Ryan Wednesday. has 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.

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