Can You Beat Inflation With Dividends?

Many investors choose dividend paying stocks for the simple reason that dividends are positively correlated with inflation most of the time and they’re hoping to not only hedge against inflation, but to beat it. When prices are rising throughout the economy, earnings tend to rise as well. This means most companies can and do hike their dividend payments.

But it’s not as simple as just finding stocks that have dividends growing faster than the rate of inflation. It turns out that in a taxable account, if inflation is high enough investors are very likely going to lose money over time. Let’s look at an example of a stock that has a total return of 4% per year due to dividends while the inflation rate is running at 3%. The dividends are taxed at 15% each year, all dividend payments are reinvested back into the stock and the investor holds onto this stock for 10 years. We will also, for the sake of simplifying the example, assume the stock price doesn’t move during this time. Using my publicly available calculator called Total Returns- Dividends vs. Price Appreciation, along with some calculations in a spreadsheet, I came up with the following outputs below:

Over 10 years, this stock sees a total return of 40%. But after taking into account inflation over this time period, the real total cumulative return is only 5% (barely 0.5% per year). In other words, half of the real return expected due to the dividend yield being 1% point higher than inflation is taken by taxes.

As inflation increases, the problem becomes worse. In fact, once inflation hits 6%, the investor will actually lose money over a 10 year time frame in real terms if we assume the total return (before taxes) from dividends will always be 1% point higher than the inflation rate.

Why is it that the real return declines as inflation goes up? The reason is that in order to pay the taxes on the dividends, more of the gains from the dividend payment have to be used. Taxes due to inflation are very sneaky that way. They eat into real returns: the higher the rate of inflation, the more in percentage terms that is lopped off of the real total return.

The examples seen here show us why investments that generate income or dividends every year, and then are taxed at the end of the year, generally belong in tax-deferred accounts if possible. Holdings that generate mostly capital gains that can be deferred until the stocks are sold should generally be held in a taxable account.

Let’s look at the same example above where this stock is in a tax-deferred account and the rate of inflation is once again 6%.

This looks quite a bit better. The real return is 18% over the 10 year time period. But what can be done if you have already maxed out what you can put into your tax-deferred accounts?

Although most people understand that capital losses can be used to offset capital gains, they don’t realize that there is a way to help offset dividends as well. There is a strategy that I have used myself whereby I take my stocks with the highest dividend yields and I buy them on the ex-dividend date and sell them the day before the next ex-dividend date. This way I get all of the price increase due to dividends, but in the form of capital gains. Because I sell on the ex-dividend date, I receive no dividends at all. At the end of the year I can offset these capital gains with capital losses I incurred years ago and effectively pay no income tax on my gains. I have used this strategy with Annaly Capital Management (NLY), which pays a hefty dividend yield of 15.1% today. Over a 10 year period, the difference in the real compounded return for NLY using this strategy (assuming the dividend yield and inflation rate stay the same) would be 73%.

I don’t recommend trying this strategy with multiple stocks at once. It would end up being a lot of work and the trading fees will add up. But you could use this for a select few individual stocks or a strong dividend paying ETF such as the Dow Jones Select Dividend ETF (DVY), which has a dividend yield of 3.5%. For more ideas on how to beat inflation over time, see my previous article on this topic here.

Bio:

Doug Carey is the owner and founder of WealthTrace. His company offers retirement planning software for financial advisors as well as individuals looking to create their own retirement plan. The WealthTrace website also offers many free financial calculators. Doug has over 16 years of experience in the financial markets. He is a Chartered Financial Analyst with a Masters degree in Economics from Miami University in Oxford, Ohio and a B.S. degree in Economics, with an emphasis in Finance, from Ball State University.