The following article discusses the “U.S. Tax Withholding on Payments to Foreign Persons” and is NOT applicable to US citizens, regardless of their country of residence. This article also discussed the inefficiencies of US domiciled securities paying dividends, and does not apply to non-US domiciled securities
The content and accuracy of this article is subject to much debate, please read the comments section below
Historically speaking, the payment of dividends was perhaps the main reason that an investor would look to own a share of a company. Even today there are many investors that manage their portfolios in a way that seeks strong dividend paying companies.
One of my favourite financial blogs to read is Dividend Mantra which covers dividend investing as a strategy to replace employment income with dividend payments.
A tricky question I often think about is how will my investment portfolio replace my income in retirement?
Without holding assets that will pay off a regular dividend, the only other option would be to sell off assets in the portfolio and realize the capital gains that they have accumulated.
However, this feels quite counter-intuitive as selling off part of your assets will obviously reduce the growth potential and reduce the earning potential of the portfolio.
In theory, provided you sell off a smaller percentage than the amount by which your portfolio has grown in the set time frame, then your investments should continue to grow.
The problem here is that this approach requires you to sell off parts of your portfolio on a regular basis, regardless of current price, and in the ideal scenario you will be selling off assets that have a history of compounding growth.
That is to say, you would be forced to sell off shares in profitable and growing businesses in order to meet your day to day spending obligations.
It is for this reason that many people prefer to hold dividend paying stocks that will continue to pay out a sum of money on a regular basis that can be used to cover living expenses, without being required to reduce any of your holdings in those companies.
This intuitively feels like a much more sustainable plan that can be maintained indefinitely and provide a passive income.
In addition to this, getting a regular dividend payment feels a lot safer and more tangible than investing in a growth fund that gives no yield back on your investment until sold for a capital gain. A dividend payment, once made, can’t be taken back and allows the price of the underlying asset to move entirely sideways, or even fall (to some extent) and you remain happy that your investment has provided you a positive yield.
Many of the larger, and more mature companies, that are publicly traded pay regular dividends and tend to increase the dividend payment amount on a consistent basis.
For example if we look at the past 5 year performance of IBM, we can see the consistent, and growing, dividend payments every quarter:
Here we can see that despite the fact that the stock has moved more or less sideways for the last 3 years, the dividends paid off during this time will have provided the investor a positive return on their investment.
This can be seen by running the numbers on a sample time-frame as follows:
For this scenario we will ignore the implications of tax and brokerage fees/commissions, and assume no dividend reinvestment, in the interests of simplicity.
Imagine a theoretical investor, Jeremy.
The date is the 15th April 2011, our boy Jeremy has $100k to invest and is looking to invest in something that will pay a steady stream of dividend income.
Jeremy notices that IBM stock is currently trading at $166.21 per share and pays a steady quarterly dividend in the region of 0.45%.
With this, Jeremy takes his $100k USD and purchases 601 shares of IBM, at a cost of $99,892.21 leaving him with 601 shares of IBM, and $107.79 in cash.
From the point of investment, until today the price of IBM shares has declined to the tune of -1.09%
However, Jeremy’s investment account currently stands at $106,364.59
An increase of 6.36%
More importantly, Jeremy has generated $6,364.59 despite the value of his shares falling by -$980.02, and without reducing his holding of 601 shares.
The breakdown over time can be seen here in the table below:
|Date||Div per share||Div paid out||Running Total|
This demonstrates the return that an investor could expect from an investment in IBM through the dividends paid out.
What is particularly good about this as an investment, is the regularity and uniformity of the dividend payments.
By understanding that your investment will pay out a predetermined amount as a set date in the future, an investor can plan his or her finances around this predictable income much as one would manage their finances around the dependable income gained through employment.
It is easy to see then, why dividend paying stocks such as IBM make idea replacements for employment income to provide for the costs of living in retirement.
In fact, the ~2% yield of IBM is actually on the lower end of the scale, with many “blue chip” stocks paying closer to 4% a year in regular, scheduled, dividends.
So, given the many benefits of investing in a dividend paying stock, why would an expat investor not want to load up their portfolio with some high yield dividend stocks and earn a steady stream of income from their capital?
US Withholding Tax
The principal reason why investing in a high yielding, US domiciled, dividend stock, is not an optimal strategy for a non US citizen is the application of “U.S. Tax Withholding on Payments to Foreign Persons”
In particular, if you live in a tax-free domicile, such as the United Arab Emirates, or a low tax domicile, such as Hong Kong, the tax withholding will be substantially higher than your rate of income tax.
In a region that has a low, or zero, rate of capital gains tax a more optimal solution would be for the the company to reinvest its profit into the business, or hold it on its balance sheet as a cash asset.
As a result, the individual share price would theoretically rise by an amount equal to the dividend that would have been paid out.
For many growth companies this is typically how they operate, and this makes them more efficient vehicles for expat investors.
However, this is but one aspect to bear in mind when evaluating and potential investment.
This issue of tax withholding does not apply to any funds that are domiciled outside of the US, for example a European stock, or a Japanese stock.
It is also worth noting that many Exchange Traded Funds that contain US domiciled assets choose to be domiciled in Ireland and traded on the London Stock Exchange.
This is due to the fact that a tax treaty is in place between the US and Ireland to reduce the level of tax withholding from 30% down to 15%.
Given the option between investing in a US domiciled ETF, or and Irish domiciled ETF that tracks the same index, there is a substantial tax benefit to be realized by investing in the Irish domiciled fund, but where possible it is better still to reduce the amount of dividends paid out from US domiciled assets.
Like many financial products, dividends are a great tool that can deliver good returns on your investment. However, when used incorrectly dividends can be an inefficient drag on any portfolio yield for any expatriate investor.