Taxation Advantages of Stocks vs. Mutual Funds

One of the advantages of the Dividend Lifestyle is that, unlike mutual funds, exchange-traded funds, or annuities, where you don’t have control over the stocks inside that packaged product, with a dividend strategy, you and your advisor have 100% choice and control over the companies you are invested in. 

I got off the phone with an investor the other day, and we were doing a review of one of his brokerage accounts, which is invested in a portfolio of individual securities. He owns all the big names we know and love.

I talked to the investor about the potential tax efficiency of these dividend-paying stocks held inside his taxable brokerage account because the only taxes this guy pays each year are on the dividends. It doesn’t matter if they’re reinvested or they’re taken out. That’s the only tax liability he has because there are no capital gains unless something is sold. Hyper-efficient from a taxation perspective.

This same individual also has a side account that he manages where he holds a handful of fly-by-night penny stocks as well as a popular Technology Fund that was the talk of the town last year. He’s lost money in this side account, particularly on the Tech fund, which is down substantially this year, over 55% YTD as of the date of this writing. But the crazy part is that every year he gets capital gains distributions and owes taxes on this fund, regardless if the fund is up or down. How does this work? Follow me here; this gets a little technical: First, remember that a mutual fund is a portfolio of many individual securities managed by a team or a fund manager who are pulling the levers behind the scenes. Anytime the fund manager sells a stock inside of their fund, even if they bought the stock ten years ago before you owned the fund, if the stock ran way up in value and they sell it this year, even though you got into the fund and have lost money, you get to participate in that capital gain. Mutual funds are one of the worst investments out there in terms of the tax inefficiencies.

Anyone who owns the mutual fund the year that the fund manager sells something for a gain has to participate equally in that capital gain tax, even if they got into the fund after the fact. You’ll see that this year. When the markets are volatile, a lot of people’s statements show that they lost 30%, but then come tax time, they get a 1099 for $4,000 for the capital gain distribution because the fund manager was actively buying and selling during the year. 

With dividend-paying stocks, you don’t have that, quite the contrary! Financial advisors and investors are able to do something called tax loss harvest. We did this at the end of the year for all of our non-qualified accounts, like taxable brokerage accounts, for example. At the end of each year, we go through our individual stocks and determine if there is anything that underperformed and makes sense to sell. Substantial tax savings can be generated by selling losers and reinvesting the proceeds into similar, but not identical, securities.

For example, in 2021, the Energy sector was pretty beat up. If an investor owned Chevron stock in a diversified portfolio of dividend-paying stocks, Chevron would have most likely been one of their few laggards as the S&P 500 was positive almost 30% last year. The investor could have sold their Chevron position, realized a capital loss, and the same day reinvested the proceeds into an Energy ETF, which preforms very closely to Chevron and has similar exposure. If the investor wanted out of Energy all together, they could always rebalance into another stock in a different sector, but the point is you can generate capital loses (which offset gains and ordinary income taxes) by rebalancing holdings in your taxable brokerage accounts. 

Disclosure: One cannot invest directly in an index. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Examples are for illustration purpose only and is not a recommendation. Dividends are not guaranteed and must be authorized by the company's board of directors.  Investments mentioned may not be suitable for all investors. Prior to making any investment decision, you should consult with your financial advisor about your individual situation. Rebalancing a non-retirement account could be a taxable event that may increase your tax liability. Consult your tax advisor to assess your situation.