Total Return vs. Dividend Income Investing

Dividend investing is all the rage. See my response to a client’s question on whether to consider switching to a dividend income philosophy below.

Hi Rich – I have been listening to the talking heads on CNBC the last few weeks during the market volatility and most seem to think that the smart move is to buy stocks that have a history of paying good dividends….. The ETF SPDR S&P Dividend, (SPY) seems like a good move…. I would like to hear your opinion on this and any other moves we might consider taking…..the current yield on this ETF is 3.2%. I look forward to hearing your thoughts…

Disclaimer: I am not recommending readers invest in the funds mentioned in this article. They are used as an example of funds used in the two different investing philosophies. Any use of these, or any funds, should be a part of a well designed investment plan. It is the author’s opinion that asset allocations and investing philosophies should be designed as a compliment to a financial plan. What you are trying to achieve in life should dictate how you invest. Go to http://findanadvisor.napfa.org to find a fee-only financial advisor.

You’ve touched on the great debate of investing for Total Return or Dividend/Income.

Total return investing is investing for maximum return with income coming from the sale of fund shares. This results in minimal dividend tax and more capital gain tax on taxable accounts. Any income from IRA accounts is of course income tax, not including Roth withdrawals.

Dividend or Income investing is buying dividend paying stocks or funds that invest in dividend paying stocks. Income comes from dividends, and little or no shares are needed to sell for income. Dividend income is taxed at a more favorable rate if it is qualified. There is a holding period to qualify dividends.

Over the last 3 years, dividend investing has been favorable. Over the the last 5 years they’ve been almost even, with slight edge going to Total Return investing. (See 3 and 5 year Total Return figures of Vanguard Total Stock Market Fund, ticker VTI and SPDR S&P Dividend fund, ticker SDYon Morningstar by clicking on the links.) My philosophy has always leaned towards Total Return, but I have a client that prefers dividend investing. We’ve compromised and put a portion in a total return fund, VTI,  and a portion in a dividend oriented fund, VIG, which is Vanguard Dividend ETF. VIG is a blend between VTI and SDY. It doesn’t pay as much as the S&P Dividend Fund (SDY), but pays more than the Vanguard Total Stock Market fund (VTI). The strategy has worked out well, but has resulted in a lot of extra income on his tax return each year.

Morningstar’s Christine Benz just wrote an article on this topic recently because it seems to be the hot topic as of late. Income vs. Total Return. Her conclusion was to use a combination of both.

Why I lean towards Total Return – My preference has always been towards total return for tax reasons. By sheltering the bonds in your 401k and IRAs, and investing in indexes in your taxable accounts, you minimize taxes. If you’ve captured tax losses in your taxable account, which has been easy to do lately, you can further reduce your taxes, should you need to sell for income in the taxable account.

My Compromise – As one begins to take income, I am open to the idea of shifting a portion of large cap allocations to dividend paying funds. Just as Ms. Benz mentions, a little of both Total Return and Income investing is probably key. I’ve always been a big believer in moderation. However; if qualified dividend rates are taken away in 2013, dividend investing may lose its moxy.