Dividends are a nuisance that should be avoided.

That's the Conventional Wisdom, broadcast regularly for the last ten years. In the odd event that you never heard it, here's a quick recap.

Publicly held corporations can operate more efficiently if they retain earnings instead of paying them out to shareholders. The corporation will benefit because it won't have to bear the cost of raising (or borrowing) money in the public markets. The shareholder will avoid receiving dividend income taxed at ordinary income rates.

A better alternative is for the company to buy in shares on a regular basis. This allows shareholders receive a cash return on their investment that is taxed at low capital gains rates, at their convenience. Everything is efficient and everyone is happy.

In fact, the Conventional Wisdom was a bad idea ten years ago. It makes even less sense today. There are three reasons for this:
  • For most investors, the real tax difference is small.
  • Most investors don't care about capital gains taxes because their primary investment vehicle is a qualified plan.
  • Dividends are more regular and more certain than capital gains.
A simple exercise and an examination of the income tax tables will demonstrate the first reason. Suppose you were offered a special stock that returned 11 percent a year. Suppose you could either receive your return as an 11 percent dividend or an 11 percent capital gain. The best after-tax return you could receive would be 8.80 percent reflecting the 20 percent tax rate on capital gains. The second best would be 8.03 percent, reflecting the 27 percent tax rate on all taxable income over $46,700 for a married couple. The difference isn't very large.

  The lowest return you could receive would be 6.75 percent, reflecting the 38.6 percent tax rate on income over $307,050. (All these tax rates are based on joint returns.) The table below shows the after-tax return at different tax rate and the amount lost to higher taxes.

Comparing After Tax Returns
Tax Rate Taxable Income Level After Tax Return Return Index Portion of Return Lost To Higher Tax Rate
20 percent NA 8.80 percent 100.0   0.0
27 $46,700 8.03    91.3    8.7 percent
30 $112,850 7.70    87.5 12.5
35 $171,950 7.15    81.3 18.7
38.6 $307,050 6.75    76.7 23.3
Source: IRS, author calculations

Now ask yourself a question. How much return would you give up to be certain you would receive a return? My guess is that most people would be willing to give up at least a tenth of their return to 'insure' they received it. Since most tax returns have top tax rates of 30 percent or less, taking current dividends over future capital gains is a sound decision for the most people.

Second fact: the low capital gains tax rate is irrelevant to the vast majority of investors. Why? Because most of our investing is done in qualified plans where withdrawals are taxed as ordinary income or, like Roth IRAs, not taxed at all.

With a big schedule of increasing contribution limits on 401k, 403b, IRA, and Roth IRA plans, we'll invest even more money in qualified plans in the future. This year, for instance, workers under age 50 can contribute $11,000 to 401k plans and $3,000 to Roth IRAs, a total of $14,000. Workers who are 50 and over can contribute $12,000 and $3,500, respectively, for a total of $15,500.

Since about 94 percent of all workers earn less than the Social Security wage base maximum, currently $84,900 , the vast majority of workers can save over 16 percent of their income in such plans. By 2006 the limits will be $20,000 and $5,000 for 401(k) and Roth IRA accounts for those 50 and over, $15,000 and $4,000 for those under 50.

This entire pool of investors--- the fastest growing body of capital in the world--- is indifferent to capital gains tax rates.

The bottom line here is that the capital gains tax rate is quaint dinosaur. It will be even more irrelevant tomorrow.

The last issue is fundamental: which return is more certain, a dividend or a capital gain?

You know the answer.