In the world of investing, there has been an ongoing debate about the importance of dividends.

Some argue that dividends are irrelevant and that total return is all that matters.

Others emphasize the value of regular cash flow from dividends, especially during retirement.

So, which side is right?

Let's take a closer look at this topic and examine real-life scenarios to determine whether dividends truly matter.

Accumulation Phase: Investing for the Future

Imagine you're 50 years old at the end of 2011, with $500,000 in your long-term investment portfolio. You plan to retire in 2023 and can invest $3,000 per month until then.

During this accumulation phase, your strategy is to reinvest all dividends, as there is no need for the additional cash flow during the accumulation phase.

To illustrate this, let's consider three well-known securities: Vanguard S&P 500 ETF ($VOO), which tracks the performance of the S&P 500; Schwab US Dividend Equity ETF ($SCHD), which focuses on high-yielding dividend equities; and Berkshire Hathaway ($BRK.A), a megacap stock that has never paid a single dividend to shareholders.

Fast forward to April 2023, and here are the results:

• $VOO: $2.92 million
• $SCHD: $2.85 million
• $BRK.A: $3.03 million

As you can see, there isn't a significant difference in the final values of these investments.

Regardless of whether you chose a dividend-focused strategy or not, the total return is what ultimately matters during the accumulation phase.

Distribution Phase: Generating Income in Retirement

Now, let's shift our focus to the distribution phase. Let’s assume you reached retirement where you have $2 million at the end of 2011 and plan to withdraw $80,000 annually, adjusted for inflation each year after.

In this scenario, you will reinvest dividends if they exceed the income required.

By April 2023, you would have enjoyed the same income every year from each investment, while also maintaining a healthy capital:

• $VOO: $6.16 million
• $SCHD: $5.94 million
• $BRK.A: $6.36 million

Once again, the difference between the total returns of these investments is not significant. Whether you received dividends or not, your overall results remain comparable.

You’ve enjoyed your retirement and had the cash flow needed to live your lifestyle in all three investments.

But, there is a problem with one of these investments in the withdrawal phase.

Selling Shares and Taxes: The Unavoidable Aspect

During retirement, you might wonder if selling shares to meet your income needs is a drawback. The reality is, yes, you would need to sell shares.

Here's how the share count changes for all three assets over time:

Having a reduced share count shouldn’t be your concern though. Sure, after 12 years of retirement, you have 28% fewer shares of Berkshire stock. But, during that same time the price of the stock increased 440%.

The problem isn’t your share count, it’s your taxes.

Interestingly, around 2015, $SCHD starts paying you more in dividends than you require for income. This means you can continue adding more shares. However, the tax implications become significant at this point.

Assuming these investments are held in a regular brokerage account, $SCHD now forces you to pay taxes on income you don't need, while $BRK.A allows you to create your own tax bill.

For instance, in 2022, $SCHD paid you a dividend of $206,922, when you only needed $104,866 in cash flow (income). This creates an unnecessary tax burden.

In 2022, the first $83,350 of long-term capital gains and qualified dividend income for married couples is taxed at 0%. This is a huge benefit for retirees whose only income comes from their long-term portfolio.

But, since $SCHD is paying you more income than you require, they are basically forcing you to take money out of your investments and give it to the government. Not ideal.

Here’s a table that shows the tax consequences of all three investments in 2022:

That’s $14,651 paid to the government that is no longer compounding inside your portfolio. A complete waste.

It's crucial to remember that total return, not just dividends, is what truly matters when it comes to investing.

Whether you're in the accumulation phase or the withdrawal phase, the ultimate goal is to maximize your overall return on investment.

Dividends, from a company's perspective, represent one of three options for utilizing excess cash on their balance sheet.

The alternatives include reinvesting in the business, issuing dividends to shareholders, or buying back stock.

For investors, it's important to recognize that seeking out a high dividend yield should not be the primary focus when constructing an investment portfolio.

Instead, the focus should be on identifying great investments, regardless of their dividend policy.

Conclusion

The debate over the significance of dividends has sparked various opinions among investors.

However, when examining real-life scenarios, it becomes evident that dividends are not the sole determining factor of investment success. Whether you choose to reinvest dividends or not, the total return is what truly drives your portfolio's growth.

Furthermore, during the withdrawal phase, taxes can play a significant role, and excessive dividend income may result in unnecessary tax burdens.

Therefore, rather than fixating on dividends, investors should prioritize finding solid investments with the potential for long-term growth and sustainable returns.

By focusing on the bigger picture and considering factors like total return, tax implications, and individual investment goals, you can make informed decisions and build a well-rounded portfolio.

Remember, in the world of investing, it's the pursuit of great investments that matters most, not just the allure of dividends.

See you next week,

Derrick 

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