Let’s face it: You probably think you pay too much in taxes.
And if you trade in and out of stocks a lot, you’re definitely handing too much over to Uncle Sam. That’s especially true if you’re trading dividend-paying stocks at a rapid clip.
See, if you hold a dividend-paying stock for less than 60 days, any dividend payments you get are considered unqualified for tax purposes.
Unqualified dividends are taxed at your ordinary tax rate. Depending on your income, that could be as high as 37%.
Qualified dividends, on the other hand, are taxed at your long-term capital gains rate: 0%, 15%, or 20%, depending on your tax bracket.
That might seem like a minor difference, but it can add up to thousands of extra dollars. And, when you reinvest your dividends, adding in the power of compound interest, it can mean serious money down the line.
How to Get “Free Money”
Let me walk you through an example of how much “free money” you can get with a little bit of patience.
First, imagine an investor named Jeff.
Jeff is a long-term, buy-and-hold, dividend growth kind of guy. He knows the market will dip and rally over the short-term. But he doesn’t let the dips bother him much.
Instead, Jeff puts a lot of thought into the stocks he buys—only investing in safe and reliable dividend-paying stocks. Then he puts his head down and watches his money grow.
Now imagine a second investor named Tim.
Tim is a lot more skittish. He buys stocks on a whim, never knowing if they’re “good” or not. And he has a bad habit of selling at the first sign of stock market trouble.
In 30 years of investing, Tim has never held a stock for more than 50 days.
Jeff and Tim are both single. And they both make $80,000 per year. So here are their tax rates:
- Short-term capital gains/ordinary income (including unqualified dividends) = 22%
- Long-term capital gains (including qualified dividends) = 15%
Now, both guys were bullish on McDonald’s (MCD) way back in 1989. So they each bought $10,000 worth of McDonald’s shares.
True to form, Jeff held on to his shares until August 2019. Tim, however, has traded his McDonald’s position erratically.
Let’s see how they did…
“Buy and Hold” Pays Off Big Time
After holding his McDonald’s shares for 30 years, Jeff’s $10,000 investment had grown to $632,986.
Jeff eventually sold his shares in August 2019. After taxes, he made a $538,038 profit. That’s because Jeff reinvested his dividends. And, when it came time to sell, he paid the lower, long-term capital gains rate of 15%.
As you can imagine, Tim was not so lucky. Any time McDonald’s share price dipped a little, Tim would panic sell… then buy back in.
Despite trading in and out of McDonald’s a slew of times over 30 years, Tim still did okay. His original $10,000 investment grew to $303,069.
But he never held his positions for more than 50 days. So his dividends were all unqualified and he had to pay the higher, short-term capital gains rate. Plus, he didn’t reinvest his dividends.
Like Jeff, Tim sold his McDonald’s shares for good in August 2019. After Uncle Sam took his 22% after each sale, Tim made a $236,393 profit.
That’s $301,645 less than our long-term investor Jeff made.
There’s a Lot You Can Do with an Extra $300,000
Jeff and Tim both turned their original $10,000 investments into significant sums. But Jeff made over $300,000 more without doing any extra work.
Think of the things you could do with an extra $300,000. It’s a solid chunk of retirement money. Or a lake house. Or four years of college (and maybe even graduate school) for your kids.
Of course, there are plenty of good reasons to sell an underperforming stock. But panic selling a “keeper” is one of the death knells of investing.
Bear in mind, it’s easy to “buy and hold” when the market seems to rise every day—like it has for the last decade.
But we’re nearing the end stages of the longest bull market in US history. Eventually, the music will stop and the party will end. And when it does, the market will pull a lot of good stocks down with the bad.
That’s one of the reasons it’s so important to look for stocks that—despite any temporary dips—will ultimately rise over the long haul. It’s much easier to avoid panic selling when you’re confident about a company’s long-term prospects.
Stocks Don’t Go Up in a Straight Line
It’s also important to remember that stock market volatility is normal. Nothing goes up in a straight line.
It’s not uncommon for the S&P 500 to sink by double digits over the course of the year. Sometimes it just takes a few months.
We saw this recently when the S&P 500 fell nearly 10% between October and December 2018. Even big names like IBM Corp. (IBM) and Visa Inc. (V) fell 26% and 18%, respectively.
Since 1990, the S&P 500 has finished the year in the red five times: 2008, 2002, 2001, 2000, and 1990. And during those years, it lost an average of 16.6%.
But here’s the key. Even though it’s not unusual for the stock market to drop over the year, it still only happened five times in the last 30 years.
In other words, the overall stock market goes up most years. Meaning growth is normal, at least in the long term.
Remembering this simple fact can keep you from panic selling good stocks and missing out on big profits down the road.