0

Take a look at the last couple of minutes of this video of Mohnish Pabrai speaking. http://vimeo.com/89140080

He seems to say that owning Berkshire is a great choice because there are no taxes to be paid.

Any idea what he means by that?

3
  • 3
    Berkshire Hathaway pays no dividends. Thus there will be no taxes until you sell. Aug 24 '14 at 17:42
  • 1
    Of course that minor convenience may not be a meaningful reason to prefer Berkshire over other investments. Depends on how much you detest filling out tax forms and how bad you are at budgeting for that. Personally, I've found reporting taxes on dividends, or even on sales, fairly painless in most cases.
    – keshlam
    Aug 24 '14 at 18:07
  • @keshlam also depends on how much money you have invested, and whether or not you have income from other sources. If you have significant income from other sources you might prefer dividend-free assets since the tax rate you'll pay on them is higher Aug 27 '14 at 6:25
4

It depends on your investment profile but basically, dividends increase your taxable income. Anyone making an income will effectively get 'lower returns' on their investments due to this effect.

If you had the choice between identical shares that either give a dividend or don't, you'll find that stock that pays a dividend has a lower price, and increases in value more slowly than stock that doesn't. (all other things being equal)

Why is that?

There's a whole bunch of economic theory behind this but in short, the current stock price is a measure of how much the company is worth combined with an estimation of how much it will be worth in the future (NPV of all future dividends is the basic model). When the company makes profit, it can keep those profits, and invest in new projects or distribute a portion of those profits to shareholders (aka dividends). Distributing the value to shareholders reduces the value of the company somewhat, but the shareholders get the money now. If the company doesn't give dividends, it has a higher value which will be reflected in a higher stock price.

So basically, all other things being equal (which they rarely are, but I digress) the price and growth difference reflects the fact that dividends are paying out now. (In other words, if you wanted non-dividend shares you could get them by buying dividend shares and re-investing the dividend as new shares every time there was a payout, and you could get dividend-share like properties by selling a percentage of non-dividend shares periodically).

From the market perspective, there is little difference between the two types of shares. However, there is a big difference when it comes to taxation.

Dividend income is taxable as part of your income right away, however taxes on capital gains only happen when you sell the asset in question, and also has a lower tax rate. If you buy and hold Berkshire Hatheway, you will not have to pay taxes on the gains you get until you decide to sell the shares, and even then the tax rate will be lower. If you are investing for retirement, this is great, since your income from other sources will be lower, so you can afford to be taxed then. In many jurisdictions, income from capital gains is subject to a different tax rate than the rest of your income, for example in the US for most people with money to invest it's either 15% or 20%, which will be lower than normal income tax would be (since most people with money to invest would be making enough to be in a higher bracket).

Say, for example, your income now is within the 25% bracket. Any dividend you get will be taxed at that rate, so let's say that the dividend is about 2% and the growth of the stock is about 4%. So, your effective growth rate after taxation is 5.5% -- you lose 0.5% from the 25% tax on the dividend. If, instead, you had stock with the same growth but no dividend it would grow at a rate of 6%. If you never withdrew the money, after 20 years, $1 in the dividend stock would be worth ~$2.92 (1.055^20), whereas $1 in the non-dividend stock would be worth ~$3.21 (1.06^20). You're talking about a difference of 30 cents per dollar invested, which doesn't seem huge but multiply it by 100,000 and you've got yourself enough money to renovate your house purely out of money that would have gone to the government instead.

The advantage here is if you are saving up for retirement, when you retire you won't have much income so the tax on the gains (even ignoring the capital gains effect above) will definitely be less then when you were working, however if you had a dividend stock you would have been paying taxes on the dividend, at a higher rate, throughout the lifetime of the investment.

This effect is why Warren Buffet pays less (proportionately) in tax than his secretary- all of his income is from capital gains at 20%, whereas if he pays her well her tax effective tax rate could be 30%+.

So, there you go, that's what Mohnish Pabrai is talking about.

There are some caveats to this. If the amount you are investing isn't large, and you are in a lower tax bracket, and the stock pays out relatively low dividends you won't really feel the difference much, even though it's there. Also, dividend vs. no dividend is hardly the highest priority when deciding what company to invest in, and you'll practically never be able to find identical companies that differ only on dividend/no dividend, so if you find a great buy you may not have a choice in the matter.

Also, there has been a trend in recent years to also make capital gains tax progressive, so people who have a higher income will also pay more in capital gains, which negates part of the benefit of non-dividend stocks (but doesn't change the growth rate effects before the sale).

There are also some theoretical arguments that dividend-paying companies should have stronger shareholders (since the company has less capital, it has to 'play nice' to get money either from new shares or from banks, which leads to less risky behavior) but it's not so cut-and-dried in real life.

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.