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Stock Dividends are valuable,
but withdrawing them is Not income

Reinvesting dividends and minimizing any withdrawals are healthy for a growing mutual fund. A few decades of growth will be very helpful to retirement (so start young to avoid missing out). Dividends are costly withdrawals, because it leaves less money to grow. Gains on reinvested dividends are compounded and gains earn more future gains, which then that gain keeps earning more future gains, etc., continually. Any withdrawal can seriously reduce future compounded gain earnings.

Near 80% of the S&P 500 companies pay dividends in some degree. See a list of these ranked by dividend. The S&P 500 index funds distribute that S&P 500 dividend proportionately to your fund shares.

Dividend income depends on viewpoint. Any withdrawal from a fund might be considered as personal retirement income, but any withdrawal is of course just subtracted from remaining fund value. It may not be obvious, but any stock dividend PAID is also subtracted from the current fund price and value. The dividend is NOT an immediate gain for the fund value (the rest of this page is the details). But if the dividend is reinvested, it is then additional fund shares that can gain in the future. But withdrawals do really limit the future compounded gains.

Many don't understand market dividends correctly or completely, and it is a deeper subject than probably imagined. If bonds are purchased directly, and held until maturity or recalled (redeemed at full face value then), dividends become income, same as any interest, except are Not compounded. But speaking of stock shares, or bonds purchased in a fund, dividends are still taxed if as income, but dividends are NOT an actual immediate income increase on that first day. Any stock or fund gains due to dividends are in the future gains of having additional shares if reinvested, but there is no income on the dividend day. This is not intuitive, but true nevertheless, because on the day the dividend is paid, the stock or fund share price is reduced by the exact dividend value. The lower share price exactly balances out the dividend amount. So it's a wash, and there is no income gain on dividend day. This is a known fact (maybe not well known, but known), and if a nonbeliever, I suggest seeing Google discussions about closing price adjustments. If you withdraw the dividend then, there is no income at all, not ever, because the fund price was adjusted down. Withdrawing dividends only withdraws your own fund's value (at the lower price). But reinvestment of dividends does buy additional shares (more shares at the lower price which is still the exact same fund value on that day). No income that day, but the additional reinvested shares do have considerable future growth value.

You might figure that since you have to pay tax anyway on the dividend this year, you might as well get the withdrawal. But in the long run, the earnings payback will be much greater if it is instead reinvested in the fund (which will increase the cost basis, reducing future tax when it is sold).

Don't misunderstand, reinvested dividends definitely are an important contribution to future income. If reinvested, they buy more shares which will have additional future earnings for years. But if you withdraw the dividends, there was No income due to the price drop. You withdraw not only their price (which is a tiny part of the loss), but also most importantly, lose their future earnings, repeated every year, compounded year after year, which would have built to a vastly larger value (there is a Dividend Withdrawal Calculator on the previous S&P 500 page). If you withdraw the dividends, the dividend is no income whatsoever. Due to the immediate price drop, it is only a simple withdrawal from your previous fund amount — which is less earnings in the future years.

Examining this dividend price drop

A 1% dividend paid by a $100 Billion company totals $1 Billion dollars (and there are Trillion dollar companies, among them are Microsoft and Apple who do pay dividends). It is assumed that the promise of a dividend to be paid has bid up the stock price expecting to receive it. But the moment it is paid, then it is not still forthcoming, and since the companies value has decreased with payment out, buyers will reduce their buy bids, and the stock price drops accordingly. The companies value is reduced by the dividend they pay out, which is a huge total value. But companies also pay out much money for many other things, which does not affect the stock price until stock buyers hear of it and decide they won't pay as much for the decreased company value. But this actual dividend price drop we see is Not because of any buyer's bid. The powers that be have already subtracted the dividend from the stock price before any sell, before the close price is actually reported.

We now pay income tax on the dividend in the current year, regardless if withdrawn or reinvested. That is just a detail of congressional law which requires it. And since tax on the dividend will be paid, buying stock with any tax paid reinvested dividends increases cost basis, compensating by lowering the final taxable value when sold. Since 2012, the brokerages are required to keep track of dividends reinvested (adds to cost basis), but unknown cost basis due to older past reinvested dividends could be a tax problem when selling older funds. But if there were no dividend tax (yet) to affect cost basis, the only cost basis we would ever need to know is the investment that we actually paid in. Tax on the dividends and the compounded final result would be paid when sold. No dividend complications a few times a year to remember. All we would need to know for taxes is shares and final price and corresponding investment cost actually paid.

I am no financial expert, but this seems simple. My notion is this dividend situation is caused by the US Congressional law. The dividend could be paid into the stock account as untaxed value gain which it would and should be for us. If the dividend is withdrawn then, the withdrawal is immediately taxed with zero cost basis. If reinvested in the stock, increasing shares, it could be left untaxed until sold and withdrawn (exactly like the all the rest of the account, since we don't know the future value until we sell it at that future time). The untaxed dividend would not increase cost basis then, it and its earning gains would just be more account gain. Buyers would surely account for the companies lower value by bidding less for the stock then (until future gains), but this would all be automatic and reasonable, and corrected by future gains. There would be no risk of unknown dividends for taxes — it's all in the final dollar value and the actual cost. It seems the correct action, and Congress still gets all the tax due, but just not as fast as they want to spend it.

A mutual fund itself is not bid for, a fund only has a computed value once a day after market close, which is its only price until the next close. A fund cannot be bought or sold until the next close. This dividend price reduction effect is due to the value and price of the stocks of the companies owned by the fund. Buyers will not pay for a dividend no longer included or expected, so the expected price goes down by the same amount when the dividend is paid out (but performed by market buyers, not by some congressional law). But dividends do lower the value of the paying companies, which in turn affects the stock price (normally done by buyers, not congressmen).

Yes, tax-wise, the fund bond dividend is considered as if income. Morningstar adds dividends to the years returns, because long term, reinvested dividends are simply added share purchases which do cause additional future gains, but first day, dividends are Not income. Yes, it is new dollars arriving into the fund, and yes, it is taxed as if income. Reinvested dividends are added to the fund Cost Basis (more shares are bought), reducing future tax when sold. And the reinvested dividend is added to future price gains when reporting fund total return. Sure sounds like income, but look at the details that actually happen. On the day the dividend is paid, the fund price is immediately adjusted down equally, reducing fund value to the same previous total value before reinvestment (so there was no income yet).

Reinvesting the dividend does buy more shares which will earn additional growth in the future, which is a big plus... the reduced price will recover and growth will be greater with more reinvested shares, as it accumulates and compounds (which is income then). But if the dividend is instead withdrawn on that first day, then there is no additional gain, not on that day or any day. It was then just a withdrawal, different in that it leaves all of the same previous shares but at the lower price (whereas ordinary withdrawals reduce the shares but don't affect the price. However the effect on fund value is the same). So don't withdraw the dividends imagining it was income. Reinvest it for greater future growth, which in time will increase income.

Numeric Example: At the moment the dividend is paid, you still have only the same value as before.

If you had 100 shares at $100 per share (value $10000) and if the dividend is $1 per share (1%), then the dividend is $1 x 100 shares = $100. But then the fund price drops by that $1 per share, to $99.

If you withdraw the dividend money, you have that worth of the $100 plus 100 shares at $99 of value $9900, which is the same $10000 total value again. You have ended it there, but there was no income, and no way to imagine it was or will be income. It was just a withdrawal then. The fund value likely will continue to increase in the future, but this withdrawn dividend has no part in it.

If you instead reinvest the dividend (strongly suggested), the reduced $99 price would buy $100/$99 = 1.0101 shares. You then have 101.0101 shares worth $99, which is 101.0101 x 99 = $10000, still the same value as before (still no income at that moment). However the reinvested 1% dividend provided 1% more shares then. So as yet on that day, there is no dollar income either way, however the 1% reinvestment does have 1.01 more shares to contribute to future growth prospects (at each such dividend, perhaps four times each year). When the fund grows, each percent of new dividend becomes larger too, every year. This does compound gains impressively, increasing future income. The shares purchased with the dividend dollars also increase the fund cost basis, so those dollars are not taxed again.

If you wait until the fund price gains back the dividend price, and then withdraw that dividend value, that gain is income, but it is still the same as withdrawing any other fund gain. It is simply just a withdrawal, which reduces fund value again.

To compare, if there were no dividend, and if you simply withdrew $100 in this same example situation, withdrawals reduce shares instead of price. The $100 is one share, so you would have the $100 plus 99 shares at $100, which again, is the same value you previously had (again, some of just moved out of the fund). Or alternately, reinvestment of the dividend also remains the same value as before, $100 plus 1.0101 shares at $99 of value $10000 again today, because it is one more share than before. But that extra share (in this example) is an additional $1 for every dollar of future price gain (basically always the 1% gain more). But as to current value, some might consider any withdrawal as income, but if it comes from money you already had, you gained no value. But future growth from the reinvested dividend is valuable, see the High Cost of withdrawing dividends on previous S&P 500 page.

So if you imagine dividends are added income that you can withdraw without affecting your remaining fund value, you might rethink this. It is Not income then, because while dividends do add cash to your account, this then lowers your fund price to the same previous total value. So it was Not income, the result is simply a withdrawal of your own fund money. Reinvested dividends do provide more shares for future price gains, however that's still the same effect as if instead the price had just been left unadjusted.

Most brokerages also have a plan for you to reinvest dividends from individual stocks. Here is Vanguard's description.

It may be hard for market beginners to believe that the dividend drops price to produce zero income gain on the day dividends are paid, reinvested or not. I'll try to help here, because it clearly does drop, which produces zero dividend income on that day. For clear factual evidence of the price drop, just look at the stock or fund stock price history (those few that show this), for example VFIAX fund prices on Yahoo.

VFIAX DateOpenHighLowCloseAdj Close
Dec 21, 2020340.80340.80340.80340.80340.80
Dec 21, 20201.386 Dividend
Dec 18, 2020343.50343.50343.50343.50342.11

On the day of the dividend ($1.386 18-Dec-2020), the VFIAX data column "Adjusted Close" price simply subtracts the exact dividend from the "Close Price (343.50 - 1.386 = 342.11). The fund price dropped because the prices of stocks in the fund dropped (those that pay a dividend). On that dividend day, this becomes the funds actual effective Close price. A stock will have approximately that same reduced price at the next day Open (however there can be other after-market action overnight confusing the numbers a bit). However a mutual fund does not have an Open price, but has only a new Close price that next day. In this example instance, the S&P 500 did also fall a bit more that next day (meaning the stocks that make up the fund dropped more).

There are differences in this reporting style among various funds and stocks, many do not show this added detail, but it is still present. Plus, the 500 individual fund companies may pay their dividend at various dates different than the S&P 500 fund passes the total along. In a few cases you might notice that the Adjusted Close price drop does not exactly match the dividend subtraction. There can be other causes for adjustment, but then verify that the stated dividend amount shown is in fact reported correct, and that it includes the Capital Gains portion of the dividend. Most historical results are correct and complete, especially the adjusted price, but I've seen a few cases that the dividend value shown did not include the capital gains portion of the dividend. A part of the dividend is often taxed as capital gains, and the rest is called Dividend, which must be what sometime confuses their computer, but the actual dividend is the total of the parts. Even if the dividend value is not reported correctly, the adjusted close price should still be correct.

The Adjusted Close prices account for corporate actions like dividends, splits, spin offs, or issuing more shares. These are actions of the individual companies in the S&P 500 fund, and the fund simply reflects the total. Some of these adjustment reasons affect all prior prices in the history. Here is a link to the math of Adjusted Close. Also many other pages about Adjusted Close are found at Google. These clearly explain that dividends drop the share price equally. Again, this is a known fact, and if a nonbeliever, I suggest seeing Google discussions about closing price adjustments.

The share price drop of a small dividend is hard to notice in the numbers, but a large dividend (perhaps only paid once a year in December) can drop your favorite stock price enough to take your breath away. :) But that price drop simply means that the dividend was paid. If you reinvest the dividend, you will still have the same value, and a few more shares. There is no devious plan doing this. The companies value does drop by the paid out dividend, which might be $Billions for them. But this is really just market action, since the stock no longer promises to pay the dividend already received by the owners, and new buyers will not bid higher to include it. True of every stock and fund that pays a dividend (and even bond funds paying interest). Any dividend lowers the price that day, so the dividend is Not income on that day. But dividend reinvestment does add a few shares (often four times each year) which certainly increases compounding of future gains.

Dividends are confusing. The term "dividend" causes beginners to imagine stock dividends are income like bank interest, but these are Not the same thing. Yes, the bank interest is added to the bank account balance, and the price of a dollar does not change, and that is income (such as the low interest rates are today).

Stock dividend dollars are also added to the fund account (as cash), however then the dividend value is subtracted by immediately dropping the stock or fund share price equally. So it is Not income on that day, the overall value is still exactly the same. Any withdrawal (dividends or otherwise) simply reduces the fund value.

But if the dividend is reinvested buying more shares, it remains still the same fund value tonight (with more shares at a lower price, computing exactly the previous value). But then the greater number of invested shares will have significantly greater future compounded gains over the next years. Reinvested dividends become highly valuable, but just Not on that first day.

Copyright © 2021 by Wayne Fulton - All rights are reserved.

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