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People sure love their dividends and what’s not to like about taking some money off the table every once in a while? The problem is taxes. Unfortunately, dividends are not the most efficient way to make money from the stock market as they are subject to income tax. To truly understand dividends, one must also consider the mechanics of returning money to investors.

Say a company’s stock is at $100, and it pays out a $10 dividend, the shares devalue to $90 after the distribution. Depending on your tax rate, you will then owe a hefty chuck of the proceeds to the government. In other words, you have actually lost money unless the company grows and more importantly, the stock goes up to make up for the loss of capital.

So, what can investors do? For one, don’t try to pick more of those stocks that pay higher dividends. In the last 20 years, the return of a typical high dividend yield fund is almost 100% lower than the broader market. Two, growth stocks have not only delivered better performance, but can also be had for lower taxes on capital gains.

Finally, if you want to use dividends for income don’t forget that you are also taking market risks when investing in equities. Imagine how happy you would be to receive a 5% dividend only to lose 50% of your capital in a market crash. Much better to buy bonds. They pay coupons and you get your money back if you hold them to maturity.


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