He Is A 68-Year-Old Making $40,000 A Year In Income From His Dividend Stocks. Building His Own “Homemade Dividend” Could Keep The Same Income While Saving Him $2,400 A Year In Taxes

Where a $2,400 Saving Comes From

A dividend is taxed in full. When you sell shares, you’re taxed only on the gain, because the rest of the money is a return of what you originally paid (your cost basis).

1. Dividend example: $40,000 of qualified dividends taxed at 15% means $6,000 in tax.

2. Homemade example: selling $40,000 of shares with a 40% basis makes a $24,000 gain. Taxed at 15%, that comes to $3,600.

3. Result: the same cash, and $2,400 a year less in tax under these assumptions.

The idea goes back to a 1961 paper by economists Merton Miller and Franco Modigliani. They reasoned that, under ideal conditions, a company’s dividend policy doesn’t change the value of its shares. An investor who wants cash can makes it by selling shares, a strategy often called a “homemade dividend.”

Writing on etf.com in March 2014, Larry Swedroe reasoned that taking cash flow and taking total return can be equivalent. He said taxable investors should generally prefer capital gains, because a dividend is taxed in full while a homemade dividend taxes only the gain. He added that investors can choose which lots to sell, including the ones with the highest cost basis. Swedroe also noted that about 60% of U.S. stocks and 40% of international stocks pay no dividend. In his view, screening for dividends leaves you less diversified without raising your expected return.

One Number Moves the Whole Result

A retiree whose shares were bought recently and have a high basis keeps most of the benefit. Someone holding decades-old shares with almost no basis saves nothing.

Five Catches That Can Erase the Math

1. The dividends have to go. The saving only works if his holdings pay little or no dividend. If he keeps the same dividend stocks and also sells shares, he still owes tax on the dividends.

2. Switching has a cost. Selling his dividend stocks to change his mix could trigger a one-time taxable gain. The annual saving starts after that, or applies right away only to someone who already holds the right mix.

3. The portfolio falls. Every sale leaves him with fewer shares, so “same income” isn’t guaranteed.

4. Timing matters. Michael James on Money has warned that selling shares during a long price decline can permanently falls your holdings. This sequence-of-returns risk applies to dividend investors too, because dividends can be cut.

5. The paperwork adds up. He has to track his basis and each lot he sells. Per IRS Publication 550, brokers report basis on Form 1099-B for covered securities, which are generally shares bought after 2010. He needs his own records for older lots.

Who This Could Work For

This approach may suit retirees who have taxable brokerage accounts, high-basis holdings and other income that already uses up the 0% bracket.

It does little for retirees still inside the 0% bracket or those with very low basis. It also doesn’t help people whose money is only in tax-deferred accounts, because those withdrawals are taxed as ordinary income no matter where the money came from.

Start by pulling up your cost basis for each lot, since that one figure shows whether there is anything to save. The costliest mistake is selling shares while still holding high-yield stocks. That adds taxable gains on top of fully taxed dividends.

This is not tax advice. Talk to a tax professional before changing how you draw retirement income.

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