Maximizing Return & Minimizing Taxes

If you have an account that is not protected from taxes (not a retirement account), then you need to factor in a defensive tax strategy when investing.  You only need to remember a few simple facts and concepts

Frequent trading – This will cause you to be subject to a higher tax rate on any profits you realize.

Dividend paying stocks – Each time you receive a dividend you are realizing a profit and therefore you are subject to taxes.

Growth stocks (no dividend payments) – Stocks that do not pay dividends do not cost you in terms of taxes until you sell them for a gain.

Example/Assumptions -  I buy 1 share of two different stocks.  Both stocks cost $50. One stock pays a 5% dividend annually and I hold the stock for 5 years.  In 5 years I sell the stock for the same price I bought it $50.  The other stock’s price appreciates 5% annually.  Both dividend gained and capital gains from selling stock are taxed at 20%.

Dividend Stock

• Annually I receive 5%, but my tax I must pay on all dividend distributions is 20%.  Therefore, I really only see a 4% dividend annually.
  • 5% div. * 20% tax rate = 1% of my dividend goes to the government
  • 5% div - 1% taxes = 4% my actual dividend to keep 
  • Over 5 years I make 20% (4% * 5 years) on my investment after taxes.

Growth Stock

The second stock I buy for $50, too.  The stock does not pay a dividend, but grows in share price by 5% annually.  After 5 years I sell the stock.

• 5% share price appreciation over 5 years causes my $50 stock to become a $63.81 stock.  (Compounding is taking place here.)
• I sell my stock for $63.81 and realize a $13.81 profit ($63.81 – $50).
• The government taxes 20% of my profit after I have sold…$13.18 * 20% = 2.76
  • $13.18 – 2.76 = $11.05
    • $11.05/$50 = 22% 
    • After 5 years I realize a 22% gain on my investment after taxes.

By avoiding taxes until when I realized my investment gain, I actually had a better return with the non-dividend paying stock than I had with the stock that paid a dividend each year.

Note - Be aware that the example above is used to show the impact of taxes.  Your tax implications might differ greatly from the simplicity illustrated through the use of a 20% flat tax rate above.