Should You Be Investing For Dividends?
What are dividends?
They are a part of the profit that a company makes, which is distributed among all its shareholders.
Why is it important?
Dividends are a way to benefit from the performance of a company whose stocks you own.
If you look up any traditional investment advice you will see dividends mentioned prominently. It is usually recommended to have good dividend paying companies in your portfolio.
This is especially true if you are looking for income generation through your stock portfolio, in addition to the capital appreciation through an increase in the stock price.
A bit of googling will throw up a list of companies who have been paying very good dividends over a number of years.
In the US, you will find an index, the S&P 500 Dividend aristocrats.
These are companies that have increased dividend payout every year for the last 25 years and have a market cap of at least $ 3 Bn.
We don’t have a similar index yet in India. However, a few minutes on www.screener.in and you will find a list of dividend-yielding stocks
Not surprisingly many of these are PSUs and names you would recognize. With a dividend yield upwards of 7% over the last few years.
Exciting, right!
You can invest in a government company (safe as houses) and get a dividend yield of 7%+.
It is!
There are a few criteria to look at when choosing a dividend stock, we will go into that in a separate post. For reference, these are: dividend payout ratio, year on year dividend growth, year on year revenue and income growth, and dividend yield ratio.
Bottom line: a healthy dividend payout over a long timeframe is a good indicator to identify strong investment picks. There is plenty written about how high dividend-paying companies have also been in the top quartile of stock gains.
However, in this post I want to talk about something else.
Should you follow this strategy of investing in dividend stocks?
Why is this even a question, isn’t this a no-brainer for everyone. Well, no, because of our familiar foe, the taxman.
In 2019, the Indian tax laws changed with regards to dividends. This has been applicable since 31st March 2020. Until it changes again, of course.
Earlier, the investor (you) did not pay tax on dividends. The company issuing the dividends paid the tax. It was still your money being used for tax, but it was paid as ‘dividend distribution tax’. The rate of the DDT was 17.65% (with a complex calculation), adding the surcharge and cess it could go all the way up to 19%.
With the new tax law, the dividend is taxed at your income tax slab rate. What this means is, the dividend income is treated as your salary income (assuming you are a salaried person) and will be taxed at the same rate as your regular income tax.
So, suddenly, for most well-paid individuals the tax rate on dividend income went from 19% to 30%+.
Therefore, if you are a salaried person earning a sizeable income it no longer makes sense to receive dividends. The effective tax rate will be the highest tax rate that is applicable to you.
Of course, in a post-retirement scenario, it might still make sense to get dividends as a steady stream of income. Not so in your active salary years, under the current tax laws.
Just to make life more interesting there are two other parts to the new dividend tax:
- The company will deduct 10% TDS and transfer the balance dividend to you. it is the same way it works with FDs. The entire dividend is your income and at the time of filing your returns, you will need to account for it and square off any balance tax.
- You can offset any interest you have paid against the tax in the process of earning that divided. This is the interest you have paid, in case you borrowed to invest in that stock or fund. (But seriously I am not sure investing with leverage is a good idea under normal circumstances.)
The whole point of a dividend strategy was to invest in an instrument that was safe (based on historic performance), paid a reasonable return and was tax efficient. With the change in tax laws, it is no longer an exciting strategy. There are savings accounts promising 6.5% and giving the same tax efficiency with better predictability.
If you had a dividend strategy ongoing or planned, you will need to rethink this in light of your tax liability. If you have a large holding in dividend companies already locked in, you will need to consider capital gains in case you are looking to switch out of dividend stocks.
Mr. Tax has got you either way!
For me, the dividend part of my portfolio was still work-in-progress and I was able to exit without much issue.
So, in summary, dividends are a good thing, but the taxman takes away a large portion of it for salaried people. No fun.
You can also read about mutual funds, the ten fundamentals and about how it started for me.
