The Zero Dividend Portfolio
Returns for stocks come in two forms, dividends and price appreciation. Across the S&P 500, the dividend yield currently sits at about 1.7%. Historically, price/share has risen at around 6-8% per year. These two sources of returns combine to produce the long term average return of 8-10% annually. This dividend is a nice feature for investors who currently need the income, and for those invested in tax-deferred accounts such as IRAs, 401(k)s and other retirement vehicles, in which taxes are postponed until the money actually leaves the account. But what about people with a large taxable portfolio, often resulting from the sale of a business, or those approaching retirement who have already maxed out contributions to these tax-deferred accounts, but who need to keep adding to their nest egg?
The problem is that taxable accounts are, well, taxable. They offer no tax deduction, and no tax-deferral; any income and realized gains in these accounts trigger tax. This is especially problematic for the savers I just referenced, who have high enough income that they cannot maintain a good savings rate by contributing only to standard retirement accounts. They have a high need and ability to put money to work, but are especially hindered when it comes to taxes on dividend income and realized gains.
But what if you could ameliorate these problems by choosing when you wanted to receive this income? What if you could postpone this income and the associated taxes to a future date when you occupy a lower tax bracket? And what if you could receive this income only in the form of tax-favored long term capital gains? And for a cherry on top, what if you could harvest short term losses from this portfolio to offset some ordinary income as well as reduce future capital gains taxes? Enter: The Zero Dividend Portfolio (credit for the original concept goes to Phil DeMuth, author of "The OverTaxed Investor").
To highlight the advantages of this strategy, let's talk about where dividends come from. Typically, dividends get paid when a company has reached positive cash flow and has extra money left over (after covering the investments necessary to keep their business relevant for the future). It isn’t unusual for such companies to pay out 20-50% of their earnings in this way. Younger, faster-growing companies tend to pay out less because they have more ambitious plans for reinvesting this cash, while more mature companies tend to pay out more.
But many companies pay out no dividends at all! They hold on to all of these profits and reinvest them to grow the business. From a taxable investor's perspective, they're essentially a tax-deferred investment vehicle. So if you construct a portfolio consisting exclusively of such companies, you greatly reduce the amount of unneeded dividend income you receive in any given year, and give yourself much greater control of when you pay taxes on the growth of these investments.
This strategy requires owning a significant number of individual stocks, a feature which may cause some investors some concern. Many have been burned by past experience with such investments, or have heard horror stories about the folly of individual stock selection. For my part, I don’t think these concerns are entirely unfounded. Markets do tend to be pretty efficient over time, and I would discourage any investor from betting big on a single stock. The data just doesn’t favor that type of approach.
What I would point out though, is that we are not seeking out the next Amazon.com, or investing in a concentrated manner. Instead, we are constructing a broad, diversified portfolio of high quality companies. Of these, some will perform very well, and others will not. But we don’t know in advance which ones are which, or over what time horizon those events will play out. So all we are doing is creating a portfolio with a high correlation to the S&P 500, but with dividend payers stripped out so as to minimize unwanted income. This correlation may not be perfect year to year, but over the longer term we should see very comparable performance. Remember, this isn't a "beat the market" portfolio, it is a tax management strategy.
The companies included in this strategy are hardly obscure. They include names like Facebook, Google, Amazon, Berkshire Hathaway, and other major holdings in the S&P 500.
My second caveat is that none of this is a guarantee that you’ll never receive unwanted portfolio income with this strategy. Your portfolio companies may decide to start paying a dividend, or they might get acquired and force you to realize a taxable gain. These aren’t necessarily bad events in themselves, but they do illustrate outcomes that you have less than perfect control over. But the portfolio as a whole should see dramatically less taxes than your typical index fund.
The other potential drawback to this strategy is what happens to this portfolio over longer periods of time. Just as an index fund features different weights to individual stocks (Apple sits at roughly 6% of that portfolio, compared with just 0.56% for Nike), your portfolio will drift towards increasing concentration in specific positions. This is a normal feature of stock investments, but it may cause some concern for investors in search of diversification. There are basically three ways in which this feature can be managed.
One way is to have a time-frame such that any one position is unlikely to become an uncomfortably large part of the portfolio, say 20%. Such an situation often takes several years to develop, particularly if you are starting with 3-4% allocations to each position. Your best way out of the concentrated position is to sell the stock in a year when you are in a low tax bracket. This might be the first year or two of retirement, a sabbatical, or just a year where you see low income from your business. Often, these low-tax years line up nicely with times when you might need to tap the portfolio for income, so you've successfully moved your tax bill from a high bracket to a low bracket. This is the ideal outcome for a zero dividend portfolio, taking income only when it's favorable, and not a moment sooner.
The second method consists of making continued portfolio contributions to dilute the impact of that one position. A $10,000 holding in a $50,000 portfolio is a 20% position (and likely a smaller portion of your overall portfolio if you count retirement accounts as well). But if you continue annual contributions of $25,000 for 3 years, that $10,000 represents only 8% of principal, which is not far off from the 6% that Apple represents in the S&P 500. Even a horrible outcome for that company going forward is unlikely to sink your financial ship.
The third way of dealing with a highly appreciated position is to use it in your charitable gifting strategy (more on this towards the end of the article). The short version, though, is that you gift shares of this stock directly to charity without paying taxes on the gain.
Finally, not all your investments will go up in value. But you can turn this to your advantage. By selling such investments, you can realize a tax-loss that offsets long term capital gains, and even some ordinary income. If you don’t need the full amount of this loss in one year, it carries forward to the next year. And this by no means precludes you from reintroducing this stock back to your portfolio after 31 days. You can remain diversified.
To recap, such a portfolio requires a unique management style, designed to address challenges that arise, as well as capitalize on opportunities.
Compare this with a scenario in which these investors put money in an S&P 500 index fund, and receive annual dividends worth roughly 1.7% of their principal. Even if this income consisted entirely of qualified dividends (it doesn’t) and were taxed at long term capital gains rates, it would still be subject to state taxes as well as medicare taxes on net investment income. In Oregon, all these taxes can add up to 34.7%! And that’s assuming a relatively benign scenario in which everything is taxed at favorable long-term capital gains rates. On just $10,000 of portfolio income, the investor ends up giving away $3,480 in taxes annually. These taxes can add up to quite a large amount of forgone wealth over time, as that $3,480 is money that gets removed from the portfolio and doesn't continue to grow.
Recall again the ideal situation for a zero dividend portfolio: an investor who does not need the income right now, and who is still trying to maximize their portfolio contributions and growth to prepare for retirement. Rather than pay taxes in this high-tax-bracket stage of their career, they actually want to defer taxes into their lower tax, retirement years. For such investors, a zero-dividend portfolio can make a lot of sense.
The potential benefits of a zero-dividend portfolio don’t end there. An even better situation, albeit a somewhat less common one, is the scenario where an investor is regularly making large charitable gifts of appreciated stock. Here, the cumbersome clustering of gains in fewer and fewer positions over time actually is a benefit to the investor, as they can gift away these appreciated gains for maximum tax benefit while keeping deferred gains in the rest of their portfolio fairly minimal.
Even if an investor only wishes to allocate a portion of their portfolio to a charitable gifting strategy (or simply wants to make gifts opportunistically when faced with a massive capital gain), a zero dividend portfolio can serve their purposes very well. After all, the earnings retained by these companies contribute to future price appreciation, rather than taxable income for the investor.
For more information about this strategy, as well as whether you might be a good candidate for a zero-dividend portfolio, please contact Nicholas for a free consultation.