I missed a day of writing so today I'm diving in deeper with some formulas and considerations for keeping your soldiers strong (Soldiers being Capital). With a Presidential Election on the Horizon, we should be focused on Taxes. We all know one of the highest paid Americans is the President, it is our Tax Dollars that fund that person (2 Million over 4 years ~ What a Salary with free everything as a Dessert coated with vanilla and chocolate!)
In today’s financial environment, many Investors face a tough decision: stick with the security of a high-interest savings account or venture into dividend-paying stocks for potentially better returns. With savings accounts offering interest rates of up to 4.5%, you might wonder how a dividend yield compares. Let’s break down how to calculate the dividend yield required to match or exceed the returns from a 4.5% savings account, taking tax advantages into consideration.
I lean towards Fundamental Data when making Investment Decisions. With that said, I don't think it's logical to purchase and Stock based on Dividends or, "Technical Data," alone. Being a NJ Native, I'd rather go play Craps or Roulette than buy a Company hoping to scalp profits or that the Company is likely to become the next Amazon. Business is extremely difficult and there is a long list of failures we could analyze. But with that little bit out of the way, and the understanding that I'm not an advisor, lets dive into some formulas and considerations to Dividend Income vs Interest Income. Oh, and obviously the later is more secure.
Understanding the Tax Difference
The primary difference between interest from a Savings Account and Dividends from Stocks lies in the way they’re taxed. Interest from Savings Accounts, or Bonds, is taxed at your Ordinary Income tax rate. For many, this could range from 22% to 37%. Dividends, on the other hand, may qualify for a lower tax rate if they are considered Qualified Dividends — typically taxed at 15% for most investors.
Because of this tax advantage, a dividend-paying Stock doesn't need to match the nominal rate of a Savings Account to provide an equivalent or even better after-tax return.
The Calculation
I've included the Tax Code for Low Income Tax Brackets. For now, let’s assume the following mix on tax rates for simplicity:
- The tax rate on Interest Income (Savings Account) is 24% (A Lower Income Bracket).
- The tax rate on Qualified Dividends is 15% (An Upper Income Bracket).
Step 1: Calculate the After-Tax Yield for the Savings Account
With a 4.5% interest rate on your Savings Account (E*Trade Premium Account Rate), you’ll need to account for the 24% tax rate. This means you won’t actually pocket the full 4.5%. Here’s the formula:
So, after paying taxes, your effective yield from the Savings Account is 3.42%.
Step 2: Calculate the Equivalent Pre-Tax Dividend Yield
Now, let’s figure out what dividend yield would give you the same after-tax return as the 4.5% savings account. Since qualified dividends are taxed at a lower rate of 15%, the formula is:
We already know that the desired after-tax return is 3.42%. Rearranging the formula to solve for the pre-tax dividend yield:
Step 3: The Dividend Yield You Need
In this scenario, a dividend yield of 4.02% would be equivalent to the after-tax return of a 4.5% savings account, assuming your dividends are taxed at the Qualified Dividend rate of 15%. Any yield above 4.02% would offer better after-tax returns than a 4.5% interest Savings Account (Specifically the current E*Trade Premium Savings interest (9/18/2024)).
Why This Matters
Understanding this calculation is critical for making informed decisions about where to place your money. While Savings Accounts or Bonds offer security and liquidity (Bonds lack liquidity relative to their terms), dividend-paying stocks have the potential to provide a similar — or even better — after-tax return, especially when factoring in the tax advantages of Qualified Dividends.
Moreover, many dividend-paying stocks not only offer immediate returns but also have the potential for price appreciation and dividend growth, which can outpace inflation and increase your overall wealth over time.
Final Thoughts
For those comfortable with some risk, dividend stocks can be an appealing alternative to high-yield savings accounts. As long as you are mindful of the tax implications and the long-term growth potential of dividends, you could enjoy better returns while still maintaining a relatively stable investment.
When making investment decisions, it’s essential to consider both the nominal rates and the tax consequences. In the example above, you see that a 4.02% dividend yield can actually outperform a 4.5% savings account yield after taxes. As always, consult with a financial advisor to ensure your investment strategy aligns with your goals and risk tolerance.
Additional Tax Thoughts:
Tax Rates on Qualified Dividends (2023 U.S. Tax Code):
- 0% Tax Rate: Individuals in the 10% or 12% income tax brackets, typically with taxable income up to $44,625 for single filers or $89,250 for married couples filing jointly, will pay 0% tax on qualified dividends.
- 15% Tax Rate: For those in higher income brackets (up to $492,300 for single filers or $553,850 for married couples), qualified dividends are taxed at 15%.
- 20% Tax Rate: The highest income earners pay a 20% tax on qualified dividends.
How This Affects the Calculation:
For individuals in the 0% tax bracket, the tax advantage is even more significant. They don’t pay any federal taxes on qualified dividends, making dividend-paying stocks a highly attractive option compared to savings accounts, which are still taxed as ordinary income.
Revised Calculation with 0% Dividend Tax Rate:
Let’s assume a person in the 0% dividend tax bracket is comparing a 4.5% savings account to dividend yields. Since qualified dividends are not taxed, the full pre-tax dividend yield is received.
In this case, to match the after-tax return of a 4.5% savings account:
Savings Account After-Tax Yield: As before, the savings account is taxed as ordinary income. At a 24% tax rate, the after-tax yield is:
Dividend Yield with 0% Tax Rate: Since dividends are taxed at 0%, you would simply need a dividend yield of 3.42% to match the savings account’s after-tax yield of 3.42%.
This makes dividend-paying stocks even more attractive for low-income individuals because they don’t need as high a yield to beat the savings account, and any yield above 3.42% provides better returns than a 4.5% savings account after taxes.
