Dividends: Everything you need to know

What are dividends? (by ChatGPT, own emphasis added)

“Dividends are a form of payment made by a corporation to its shareholders. They represent a portion of the company's profits that are distributed to the owners or investors in the form of cash or additional shares of stock. 

When a company earns profits, it has the option to reinvest those profits back into the business for growth and expansion or distribute them to shareholders as dividends. The decision to pay dividends is usually made by the company's board of directors, taking into consideration various factors such as financial performance, future growth prospects, and the company's capital requirements.

Dividends are often considered a way for companies to share their financial success with shareholders, providing them with a direct return on their investment. Many investors, particularly those seeking income from their investments, look for companies that pay regular dividends. However, not all companies pay dividends, especially those in the growth phase that prefer to reinvest their profits for expansion or research and development.”

ChatGPT nicely summarized the key characteristics of dividends. We emphasized a few points above that we would like to explain a bit more. But first, we will answer a question we often receive.

Can I live off my dividends?

At Selma, we invest mainly through ETFs. Some investors prefer ETFs that “distribute”, i.e. pay out dividends to investors directly. The idea of living from regular dividend income is probably everyone’s dream. However, this is actually fairly hard to achieve.

Let’s optimistically assume a 5% dividend yield from a very dividend-focused, but still well-spread, investment strategy. There is a 35% tax on dividends, which you probably cannot fully reclaim, if you are living off dividends and you don’t have a regular salary anymore. So, 3.25% are left after taxes. Then you’d need to invest over 1.8 million CHF into such a strategy, even if you manage to get by with just 60'000 CHF of living expenses per year. If your portfolio is smaller than 1.8 million, you’d start to eat away the pile of money until, at some point, nothing is left. 🪫

Why should I reinvest my dividends?

The example above showed us that living off dividends is not easy to achieve. Now, you may think that you could at least improve your regular income a bit with dividends. While this sounds enticing, Selma’s answer would be: “Please don’t, if you have any other choice!”. The reason is something called “the power of compounding”.

If you reinvest your dividends, they can exponentially increase your wealth over time. In other words, you sacrifice some short-term payouts for bigger long-term gains. 🚀

The advantage of accumulating ETFs

Many ETFs are offered in two versions: accumulating and distributing. The former means that the fund manager is automatically reinvesting the dividends that are paid out by the companies included in the ETF. The beauty of this is that the money gets immediately reinvested, maximizing the power of compounding. It also saves you trading fees that you would incur if you had to do it yourself. 😮‍💨

At Selma, we thus try to pick the accumulating ETF version whenever feasible, i.e. when they come with the same management fee and no other disadvantages. This may not always be possible, which is why a Selma portfolio will still have a mix of accumulating and distributing ETFs.

Taxation treats all dividends equally (except for some)

For your annual Swiss tax report, it doesn’t matter whether the dividends got paid out or have been reinvested by the ETF. Both are taxed identically.

However, there is another important taxation aspect with dividends, and it mainly affects dividends from US companies: They get taxed twice on their way from the US company to you. Thanks to a preferential tax treaty with the US, ETFs with a domicile in Ireland have to deduct only 15% from the dividends, while ETFs in other European countries have to deduct the full 30% US tax. Selma thus prefers ETFs domiciled in Ireland whenever feasible.

Not all companies pay dividends

It is important to keep in mind that not all companies pay dividends. If you focus your investment strategy on companies that pay dividends, you will miss out on a lot of other companies. These companies may actually be interesting, because they reinvest their earnings into growing their business, rather than paying out earnings immediately to their shareholders. Famous examples are Amazon and Google (or rather its “Alphabet” stock market listing), who have never paid out dividends during their roughly 20 years in the stock market.

Conclusion

At Selma, we optimize the handling of dividends to get the most out of them. This includes picking ETFs that have…

• a preferential tax treatment for dividends
• and reinvest them immediately in order to benefit from the power of compounding.

That being said, we prefer broadly spread (aka “well diversified”) investments over a focus on dividend-paying stocks. As we have shown above, focusing the investment strategy on dividends can create various problems. Living off from dividends is not feasible, unless your financial wealth amounts to several millions of Swiss francs. Even then, you will give up better long-term return prospects for your dividend-heavy strategy.