The intermittent chill in the air reminds us that summer is gone, and autumn is gaining hold, even here in North Florida. As year-end 2019 approaches, the financial planning community turns to Tax Planning and Required Minimum Distributions. Today we will concentrate on a portion of Tax Planning called “Buying a Dividend.”
Dividends are nice, as they give us positive financial feedback that our investments are working for us. Sometimes, however, good tax planning would have us avoid a dividend in order to reduce our potential taxable income. Avoiding a dividend is sometimes as easy as postponing an intended equity purchase.
When a company pays a dividend, it is taxable to the owner of the shares on which the dividend was paid. If the owner has the asset in a tax-deferred account, no current tax will be due, as it will be delayed until money is drawn from the account. If the owner of the shares is a mutual fund, the funds keeps a record of the dividend, and at least once per year pays the accumulated dividends to the shareholders of the fund.
There is no avoiding taxation of dividends forever, except to hold the shares in a Roth IRA or Roth 401(k). Note that taxpayers who are in the lowest two tax brackets are taxed on dividends at a rate of zero, essentially eliminating the tax. They do need to include the dividends in computing their total income, so the dividends are included in the tax formula.
Understanding the term “Buying a Dividend” requires understanding the steps that lead to a dividend being paid:
- The Board of Directors determines (“declares”) the amount and payment date of a dividend on the Declaration Date
- The Board then determines the Record Date, when owners of shares at the close of businesses will qualify to receive the dividend when it is paid
- The day following the Record Date is called the Ex-Dividend Date, meaning that buyers of new shares beginning that day will not receive the dividend just declared
- Finally comes the Payment Date, which is the day on which the actual dividend will paid to shareholders at the close of the Record Date
On the Ex-Dividend Date, the opening market price of the share is reduced from the previous closing by the amount of the dividend. For example, if a $20.00 per share stock or mutual fund declares a $1 dividend, on the Ex-Dividend Date (the first day that a purchase will not earn you the dividend), the market share opens at $19.00. For example, Purchaser “A” buys a $20.00 share on the Record Date, and on the next day owns a $19.00 share and a $1.00 Dividend, which will be paid on the upcoming Payment Date. Notably, that purchaser also has a tax bill for the $1.00 dividend.
Purchaser “B” buys a share on the Ex-Dividend Date, and only pays $19.00, the opening price, but has no $1.00 dividend, and no tax bill. Both “A” and “B” have the amount paid, except “A” has incurred a tax liability.
If Purchaser “A” bought the share in a tax-deferred account, there is no problem. However, if “A” bought the share in a taxable account, taxes will be owed for the year of the dividend. Only if the dividend is paid to “A” in cash will the money be available. If, instead, the dividend is reinvested in fractional shares, the tax money will have to come from another source. “A” just Bought a Dividend, and should have planned and executed the purchase on the Ex-Dividend Date, rather than the Record Date. What a difference 24 hours would have made.
Determining the ex-dividend date is as easy as going to the website of the stock or mutual fund and looking for the notice of size and date of coming distributions. Most funds have not yet determined that date for 2019, but through periodic checking, a potential buyer will be able to time the purchase after the announcement is made.
We have seen many examples of investors getting stung by a large tax bill from mis-timing purchases of mutual funds. Of course, once investors own the shares, the next dividend will be an unavoidable taxable event. Just don’t add insult to injury by getting an unwanted distribution “up front.”
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