Dividend stocks are a great way to start earning a passive income and achieve long-term compounded growth. They are usually taxed as income, but not all of them are taxed in the same way. So, should you have dividend stocks in your taxable account?
You should not buy dividend stocks in a taxable account because the dividends will trigger plenty of taxable events. It is better to hold dividend shares in non-taxable accounts like an IRA or 401(k). Your taxable account should ideally contain growth stocks and/or passively managed funds.
In this article, I will explain in more detail why dividend stocks are not ideal to have in your taxable account.
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Why You Should Not Have Dividend Stocks in a Taxable Account?
A taxable account lets you buy and sell securities on the stock market, such as stocks, bonds, and funds. It is called “taxable” because any profit you make from the account each year is taxed at your current income tax rate.
You can open a taxable account through an online brokerage or an investment firm.
Dividend stocks are companies on the stock market that award dividends to their shareholders. Most companies pay dividends quarterly, but sometimes they pay semi-annually and annually. Whether a dividend is qualified or non-qualified will have an impact on how it is taxed.
There are three main reasons why holding your dividend shares in a taxable account isn’t a good idea. Let’s take a look at them now.
Dividends Will Trigger Too Many Tax Events
Dividend stocks are a great investment vehicle and should undoubtedly be a part of your portfolio. However, it would be much better to hold them in a non-taxable account like a 401(k) or an IRA.
The reason for this is because if you choose to collect dividends from your taxable account, you will have to pay taxes on that income at the end of each year. But holding the shares in a tax-advantaged account allows you to avoid that and keep the total profit from your dividends.
Whether you reinvest the dividends or not, you will still have to pay taxes on them in a taxable account, which means that you will be paying taxes on money that you don’t need.
Qualified Dividends
The only case where you should consider having dividend stock in a taxable account is to create a passive income stream that you can take out from the account when you wish. In this case, you should invest in companies that pay qualified dividends.
Qualified dividends are taxed based on capital gains rates instead of the federal income tax rates.
The rates for qualified dividends can be 20%, 15%, or 0%, depending on your tax bracket. These lower rates can significantly impact the amount of tax you will pay for your dividends, which is why qualified dividends are much better for taxable accounts.
There Are Better Options for Taxable Accounts
Sure, having dividend shares in your taxable account can still be a solid investment, especially if they are qualified. However, if you want to maximize the profit from your investments, paying taxes for the dividends each year is less than ideal.
Instead, you should look at investing in some of these securities for your taxable account and save the dividends for your IRA or 401(k):
- Growth stocks should be the primary focus for your taxable account. These stocks are expected to grow at a more significant rate than the average growth rate of the market. Growth stocks don’t pay dividends because the companies are eager to grow and typically reinvest all of their profits back into the business to maximize growth.
- Passively managed funds are much better for a taxable account than actively managed ones because they don’t trigger as many taxable events. Actively managed funds attempt to beat the market by constantly buying and selling shares.
On the other hand, passive funds like an index ETF follow a single index and rarely change their holdings. Also, ETFs are better for taxable accounts than traditional mutual funds because they usually generate fewer tax liabilities.
Your Profit Will Be Insignificant
Dividend shares are excellent for long-term growth. You can have them in your retirement account for a few decades, and thanks to compounded growth due to reinvestment, they will sky-rocket in value and bring you a lot of profit.
However, if kept in your regular trading account, the profit you earn from dividend stocks will be pretty insignificant in the short term.
Even the highest-yielding dividend shares of 5-6% will bring very little return.
For example, if you invest $1,000 in a single dividend stock, your balance at the end of the year will only increase by $60 with a 6% yield. And that’s without even counting the capital or income tax you will have to pay.
To get any significant value from dividends as a passive income stream in the short term, you will have to invest a substantial amount of money.
To achieve the full power of dividend investing, you should see it as a long-term strategy that will pay off a few decades into the future. That’s why having the dividend share in your retirement account would be more beneficial than having them in a taxable account.
You will not only have better tax benefits, but you will also enjoy the actual value of dividend investing once your retirement account matures.
When You Should Invest With a Taxable Account?
Since retirement accounts come with many tax benefits, that’s what most people go with, especially for long-term investing. If you still haven’t started saving for retirement through a 401(k) or IRA (individual retirement account), you should seriously consider doing so before opening a regular trading account.
However, that is not to say that taxable accounts have no use at all. They can be the go-to option for a few reasons, which we’ll discuss right now.
Can Be Used for Retirement
Retirement plans have a yearly contribution limit that you can’t surpass. For example, IRAs only allow for a maximum of $6,000 annual contribution, or $7,000 for people over 50.
If you have reached your yearly limit with your retirement accounts, you could add some of your savings to a taxable account and into some retirement-friendly investments such as index funds or bonds.
To minimize taxes, you can stick with tax-managed funds or tax-exempt bonds.
When You Need More Flexibility
Taxable accounts are much more flexible than your retirement account, both in terms of investment options and how easy it is to take out your money.
With a taxable account, you are free to take any amount you want tax-free whenever you need it. On the other hand, if you’re going to take out money from your retirement account before the age of 60, you will have to pay a penalty.
Additionally, taxable accounts offer more investment options, and you are free to pursue the investment strategies you prefer. For example, options trading and cryptocurrency investing are much easier with a taxable account.
You Can Avoid Required Minimum Distributions
The law requires retirement account holders to start taking contributions by the age of 72. The only exception to this is Roth IRAs. With a taxable account, you can stay invested for as long as you want, and you will never be required to start taking out your money from the account.
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Conclusion
Dividend stocks can be a valuable component of both a taxable and a tax-advantaged investment account. Generally, though, it is much better to avoid having dividend stocks in a taxable account unless you go for qualified dividends that come with their own tax advantages.
For a taxable account, growth stocks and passively managed ETFs are a better option. Dividend stocks are better off staying in a retirement account because they are great for achieving long-term compounded growth.
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