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Stock Buybacks vs Paying A Dividend

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Famed investor Warren Buffett knows a thing or two about tax law and he knows how to help those who invest with him. He recently announced something (and also didn’t announce something) that works in the favor of all of his Berkshire Hathaway investors and many didn’t even notice.

There’s no doubt that every income investor loves a dividend. These interest type payments provide steady income regardless of short term, non-systemic market conditions but there’s a problem with dividends. When you’re a stock holder you know that you don’t have to pay taxes on your gains until you sell the stock.

That is especially advantageous for long term investors because this type of tax treatment allows somebody with a taxable brokerage account to run it like an IRA without contribution limits. It is rarely as simple as that but in theory, a stock investor who had a portfolio of stocks that paid no dividends wouldn’t pay any taxes in years where they sold nothing.

dividendsDividends, while attractive as a steady source of income are taxed each year at a rate of 15% provided you “qualify”. (We’ll talk about qualified dividends in another article) Although this may change if the Bush tax cuts are repealed, as of now the 15% rate is much better than being taxed at your normal income tax bracket but you still have a tax liability on those dividends in your taxable account. (If you have a traditional IRA you won’t pay taxes until you begin to receive payouts.)

Warren Buffett knows that if he issues a dividend. A dividend it cashes you out of some of your holdings. Let’s say you purchased 100 shares of stock for $50 per share for a total of $5,000. Then, that company declares a $2 dividend. On the ex-dividend day, your $50 stock (assuming it didn’t move in price) becomes a $48 stock and you later receive a $200 dividend payout. Rather than keeping your money in the stock, you receive the dividend and get to pay at least a 15% dividend tax.

Buyback Example

But what if that same company bought back enough shares of their stock to make the value of your $50 stock rise $2 to $52 per share? You don’t have any tax to pay because you didn’t take a payout. You’ll pay it later but every penny you save in taxes is money that continues to compound for you.

Don’t think it’s a big deal? 15% of your $200 dividend check is $30. If you were to lose $30 per year from the tax you paid on those dividends, you’ve lost out on about $2,300 after 30 years.

Warren Buffett knows a thing or two about taxes because that’s what he plans to do. It saves his company money and it saves you money if you’re a share holder.

Bottom Line

Don’t get caught up in the thinking that dividends are good and everything else isn’t. Investing offers nothing for free. When you see a buyback, remember that your share price will rise because of it and when you see a dividend, remember that it’s steady income but your losing 15% of your money that will no longer compound unless you deposit enough additional funds to make up for the tax loss.

Author:Graham