When To Use High Dividend Funds

Question

I recently heard that one way to retire is to accumulate enough wealth and then invest in a high dividend portfolio. That way, you can live off the dividends and not have to sell your stocks. So you don't have to worry about outliving your assets, etc. I like the idea of this so I could leave things to my children, charities, etc.

Right now, I have most of my money invested in an assortment of stocks that aren't high dividend. My understanding is that high dividend stocks don't grow as much (because they're paying larger dividends rather than re-investing in the company), so it's better to invest in growth funds until you're older.

But, when I get to the point of retirement and want to change my investment makeup, won't I end up paying a lot of capital gains tax? For example, imagine if I invested $100k in a mutual fund over my career and it grows to $250k by the time I retire. Now I want to change my portfolio to a high dividend one. My understanding is that I'll need to sell my mutual fund, pay capital gains on the $150k, and then invest in the high dividends. But then when I live off the dividends, I'll have to pay tax on the dividends (just like I would have if I originally invested my $100k in a high dividend fund).

So overall, is there any way to determine whether it's better to

1. Just invest in a high dividend fund from the get-go, so you only ever pay the dividend tax and don't pay the capital gains tax
2. Keep investing in higher yield funds until you retire, because those will grow substantially more than the high dividend funds to the point that the capital gains tax still doesn't make your end result less

Also, my understanding is that for retirement accounts (401k and traditional IRAs) this doesn't matter because you don't pay tax until you withdraw so you can rebalance as much as you like. Is this correct?

Answer 1

You are under the assumption that dividends are for free. But they are not. When a company pays out a billion to its shareholders via dividends, the value of the company will be reduced by that billion and this is reflected in the price.

Therefore it does not really make a difference whether you sell 2% of your stocks or get a 2% dividend. There is however a difference with respect to taxes. All the dividends you receive along the way are taxed immediately while price appreciation is only taxed when you realize gains.

Answer 2

You can have it both ways with dividend stocks: Automatically reinvest the dividends during your working career, which means higher growth for your personal portfolio. Then in retirement, switch off the automatic reinvestments and use the dividends as current income.

However, Warren Buffett advises amateur investors to just save as much as you can into a regular US index fund, reinvest dividends, and never sell. He doesn't recommend dividend investing per se.

Answer 3

I recently heard that one way to retire is to accumulate enough wealth and then invest in a high dividend portfolio. That way, you can live off the dividends and not have to sell your stocks. So you don't have to worry about outliving your assets, etc. I like the idea of this so I could leave things to my children, charities, etc.

This is one way some people fund their retirement. They invest in companies and funds when they are young that focus on growth, and then become more conservative as they approach and reach retirement. Some people view investing in companies in a way that will focus on dividends as an acceptable approach during their retirement years. It can be argued what approach is the best but it is a valid way among a multitude of valid ways to approach retirement.

But, when I get to the point of retirement and want to change my investment makeup, won't I end up paying a lot of capital gains tax? For example, imagine if I invested $100k in a mutual fund over my career and it grows to $250k by the time I retire. Now I want to change my portfolio to a high dividend one. My understanding is that I'll need to sell my mutual fund, pay capital gains on the $150k, and then invest in the high dividends.

If you have your money invested in a taxable account, then yes if you sell your shares and they have grown in value, you could owe capital gains taxes. The amount would depend on your other income, and how long you have owned those shares.

Also, my understanding is that for retirement accounts (401k and traditional IRAs) this doesn't matter because you don't pay tax until you withdraw so you can rebalance as much as you like. Is this correct?

Yes this is correct. One of the strengths of a 401(k) or IRA is that there are no capital gains taxes due as long as you keep the funds withing the retirement account. So if your plan is to start transitioning from non-dividend investments to dividend investments then the selling of the shares will not trigger any taxes.

You ask if you should start with the dividend stocks/funds now.

The answer is invest the money in retirement account in the way you are comfortable now, and then adjust your mix as you approach retirement. Those moves inside the retirement accounts won't trigger taxes.

How you decide to invest non-retirement accounts is a different matter. You don't have as much flexibility to sell investments without triggering taxes, so changes in focus come with a cost.