How Dividend Reinvestment Works

How Dividend Reinvesting Is A Great Path To Prosperity For W2 Employees

 

How Dividend Investing enables W2 Employees to build passive wealth

As W2 Employees we pay the most taxes, have the least write off’s, and fewer options than business owners to grow our wealth.  But, we’re not complaining, because we’re the consummate ‘middle class’!

We’re proud tax-payers, we’re the ‘wake-up-and-go-to-work-kinda-people’ who know that it’s our ‘labor’ that contributes to making this country function in a productive manner.  Without us, they’d be screwed.

That’s not to say we don’t strive for more, in fact a great deal of us do.  We just have to do it in a side hustle, passive-income-kinda-way, until we’re in a position to retire, or embark on a journey of working for ourselves.

But, as W2 investors, one of the greatest ways we can use to leverage our W2 Income is through Dividend Investing, and using a Dividend Reinvesting Program (DRIP).

What is a Dividend Reinvesting Program

A Dividend Reinvestment Program (DRIP) is a passive way of using dividend payments from the stocks you own, to accumulate more shares of stock.  DRIP programs automatically reinvest the dividend payment into buying more shares at the current trading price.  There are many benefits to using a DRIP program, here are three:

How reinvesting dividends lowers the ‘cost basis’ of the stock you own.

Even if you think you paid too much for the stock when you bought it, over time the DRIP program brings your average cost basis down.  Let’s say you start off with 100 Shares of Pfizer Stock (PFE) which is trading for $51 Per share.  This $5100 investment will afford you 4 quarterly payments of free Pfizer shares at a current yield of 3.09% in year one.

So, at this yield you would receive $1.60 for each share you own over the next year.  This equates to $160 of free Pfizer Stock.  The Dividend Reinvestment Program will automatically buy you more shares with this free $160, bringing your total shares to 103.1372 after year one.

Your initial investment is still $5100, but the value of the Pfizer Stock is now $5260 (assuming the price stays the same). This brings your cost basis down to $49.45 per share rather than the $51 you originally paid.  It so genius, and imagine the impact of owning it for 10 years!

In fact, here is a 5 year chart of Pfizer Stock with a $5000 initial investment.  The first chart shows the shares being reinvested and the second one where they are not:

Why reinvest dividends

Why reinvest dividends

A difference of monumental proportions! 

These charts illustrate the huge opportunity cost of not using a DRIP Program.

First of all, the Return on Investment (ROI) over a 5 year period is a whopping 34.12% difference which truly speaks for itself.  That kind of return is like the bank paying you interest on $5000, after 100 years!  And, you get it in just over one presidential cycle!  Also, you earned 32.94 shares during that 5 years, which are also earning more shares.

Also, initially you were able to get 153.91 shares with a $5000 investment.  Today, that same $5000 investment would only net you 96.58 shares, which means it may take you another 7 years of reinvesting dividends to get you to the original 153.91 shares.  This represents a huge opportunity cost!

In all fairness though, if you had not reinvested the dividends, you did have the option to spend the dividend payments at points throughout the 5 years.

How DRIP Programs make it easy to just ‘set it and forget it’.

The great thing is you can just set it up and forget about it, and get out of the way of the compounding snowball!  It’s true, when you buy the initial shares of stock you’re able to designate whether or not to enter the position into the DRIP Program.  Once set up, the DRIP program continues to reinvest in new shares with each annual, quarterly, or monthly dividend received.

If you’re using an electronic trading platform like Etrade or TD Ameritrade, you can simply click a button to enter it into the Dividend Reinvestment Program.  Soon you’ll look at the account and see; not only has the share price gone up, but you have accumulated numerous shares just for holding the stock.

How Reinvested Dividends are taxed.

Dividend Payments fall into two categories from the IRS’ perspective.   Qualified or Non-Qualified.  The chart below illustrates the 2021 Qualified Dividend Tax Rates for dividend payments, and how it relates to the shareholders overall income.

Non-Qualified Dividend Payments on the other hand are taxed as Ordinary Income and are taxed at the Adjusted Tax Rate of the payer, which can be as high as 37%, so 15-20% represents a huge tax savings.

Dividend Reinvesting is

Let’s look closer at what the difference is between Qualified and Non-Qualified Dividend Payments:

What is a Qualified Dividend Payment

For a dividend to be considered qualified, it must meet certain requirements, which include:

  1. Dividend must have been paid by a US corporation or a ‘qualified foreign corporation’.  For the foreign corporation to be considered ‘Qualified” it must be traded on a US Exchange, or located in a country who has a tax treaty or an information sharing agreement with the US, or is simply approved by the Treasury Department.

  2. If the dividend is paid to a shareholder with both a Long and a Short position in the stock, then the dividend in not considered ‘Qualified’.

  3. The investor must have held the underlying stock for at least 60 days during the 121-day period, which begins 60 days before the Ex-Dividend Date.  The image below illustrates this requirement.

How to tell if your dividend is Qualified

What is a Non-Qualified or ‘Ordinary’ Dividend Payment?

A Non-Qualified Dividend is one which fails to meet the IRS’s requirements of a Qualified Dividend Payment.  Non-Qualified Dividend payments are taxed as ordinary income and are subject to the recipients tax bracket, which in many cases, can be as high as 37%.

  • Dividends paid by certain foreign companies may or may not be qualified. A foreign company’s dividends may be disqualified if it isn’t part of a comprehensive income tax treaty with the U.S. or its stock isn’t readily tradable on an established U.S. securities market. 
  • Dividends from passive foreign investment companies aren’t qualified. 
  • Distributions from certain U.S. entities, such as real estate investment trusts (REITS) and master limited partnerships (MLPs) are taxed as ‘ordinary income’.
  • Dividends paid on employee stock options.
  • Special dividend payments and one-time dividend payments are not qualified dividends.
  • Dividends that don’t meet the IRS’s minimum holding period, as referenced above, do not meet the requirements of a “Qualified Dividend”, and therefore are subject to a higher tax rate.

Is it possible to turn your Non-Qualified Dividends into Qualified Dividends

It is certainly possible to turn your Non-Qualified Dividends into Qualified, and the best way to do this, is to simply stay in your positions for longer than 60 days.  Now, there are times when holding a position turns into a liability or at least an opportunity cost.

If so, calculate the Time Value of that money and, if it makes sense, take the profit and get out.  Or, if your profit is so large, and liquidating would cover your “Ordinary” or Non-Qualified tax liability, then it may make more sense to get out and pay the increased tax.

Why are Qualified Dividends taxed at a lower rate than Non-Qualified Dividends.

The thinking behind the lower tax rate for Qualified Dividends was simple; for companies to use the tax rate as an incentive to turn shareholders into ‘Long-Term’ Shareholders.

In 2003 the Jobs Growth Tax Relief and Reconciliation Act lowered the taxable rate on Long-Term capital gains to 15%.  The ‘Act’ was signed into law by the 43rd President of the United States, George W. Bush, and became known as the “Bush Tax Cuts”.

After the attacks of September 11th 2001, and the 2001 Recession, the Nation was looking for a way to celebrate unity and spur investment in the US, and what better way than to put more money back into the hands of its citizens.

How the Tax Rate increased as part of The American Taxpayer Relief Act of 2012

The 15% tax rate on ‘Long-Term” capital gains had a nice run, of nearly 10 years.  But, like the ‘winds of change’, the new Administration and the ‘adjustment’ in philosophy in Washington D.C. saw an opportunity for increased tax revenue, so as part of the The American Taxpayer Relief Act of 2012 it was changed to 20%.

Seems contradictory to call it The American Taxpayer Relief Act, when you actually raise tax rates on The American Taxpayer.  But, like politics and money which by the way are not mutually exclusive, calling it “Taxpayer Relief” is simply a nice euphemism for spreading the wealth from one person to another.

 

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