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In pursuit of financial freedom, we can generate residual income in a number of ways that require varying degrees of action and upkeep. But if we’re looking for completely passive income, with virtually no required action besides buying the asset, then income from dividends, interest and capital gains becomes immediately attractive!

But are these three cash flow options equal in effectiveness?

Is one better than another?

Can they be combined effectively to reach certain goals?

Taking a deep dive into these different methods of cash flow, let’s explore the answers to these questions!

Dividends: Purpose, Taxation and Price Effects

When a company pays a dividend, it is choosing to pay out part of its retained earnings (after expenses) to shareholders instead of reinvesting the earnings back into the business.

Depending on the business model and where it is in its growth phase, a shareholder may prefer the payout of earnings today rather than allowing the company to use that money to potentially grow its business, particularly if the business is in its mature phase and not likely to experience above average growth in the future.

Think of it this way. If someone offered you $100 today or the chance at up to $500 next month, which would you choose? My guess is you’d probably be willing to wait out the month for the possibility of so much more than the original offer. But if they could only offer you the chance at $150 next month, then the decision may not be quite so obvious. Is $100 today worth more to you then a possible $150 next month? Now we’re probably closer to 50/50 draw on which one we’d choose. Maybe it’s best to just take the money now, since there aren’t any guarantees we’ll even get to $150, and it’s not radically different than what we’re offered today.

Now don’t misunderstand what I’m trying to say. A company that pays a dividend can still grow just as much or more than one that doesn’t. But essentially cash paid as a dividend is money that is not being reinvested back into the company. The company may even have a huge budget for reinvesting into their growth, but they still had earnings left over that could not be made efficient use of. Or they may like the perceived credibility that a dividend provides to investors who enjoy seeing that paycheck every so often.

It’s important to keep in mind that as of 2024, qualified dividends are taxed at the same rate as long-term capital gains (three tiers of 0%, 15% and 20%). Also, ordinary dividends and short-term capital gains are taxed at the same rate based on the current income tax brackets.

Unless you’re buying and selling stock constantly, most dividends you receive are likely to be qualified. A dividend is typically classified as “ordinary” if you purchased the stock very near to the ex-dividend date (within the previous 60 days). The higher tax of an ordinary dividend is simply there to discourage investors from buying a stock just to receive the dividend, and then selling it immediately afterward.

So here’s what that means. If you’re playing the long-term game, then taxation is going to be the same whether your receive a qualified dividend or a long-term capital gain. If you’re day trading, the taxation is still going to be similar whether you earn an ordinary dividend or a short-term capital gain.

This similarity of taxation encourages an investor to be indifferent whether the stock uses a dividend-paying strategy or a growth strategy as their means of returning value to the shareholder.

In theory, when a dividend is paid (technically after what is called the ex-dividend date), a stock value usually drops by approximately the amount of the dividend. The reason for this is that the earnings paid out in the dividend were part of what made up the value of the stock. When it is paid out, it is no longer a part of the company’s net worth.

In practice, this 1:1 drop in price doesn’t always happen exactly, as the price is determined by more than simply the value of retained earnings. The market forces also take into account the potential for future earnings which are constantly being assessed and reassessed in real time by supply and demand from investors.

But it’s important to understand this concept, because a common misconception is that a dividend adds to the total return of a stock. Unfortunately, that is a false perception. The stock price is negatively impacted by the payout of a dividend. All things being equal, a stock’s absolute return should (in theory) be the same whether it pays dividends or not.

It’s not useful to think of dividends as some sort of extra return from a stock. It is simply another way that a company can return value to shareholders, as opposed to focusing entirely on the generation of future earnings through the reinvestment of present earnings.

That said, some people prefer dividends because of the simplicity of a regular and automatic cash inflow from investments to provide them with something akin to a paycheck. But it should also be remembered that a similar thing can be accomplished through an automatic and regular sale of funds, which would result in a predictable cash amount to use for spending.

Interest: Purpose, Tax Strategies and Risk-Reward

When generating interest through ownership of a corporate bond or holding cash in an interest-bearing savings account, the interest rate is generally going to be taxed at the ordinary income rate. 

Depending on one’s marginal rate of income, this can provide an incentive to focus on dividends and/or capital gains instead of interest.

However, taxes are not the only thing to be considered when making decisions of how much to hold in interest-bearing assets. The reason they bear interest is because the investor has made a loan to the company or government which issued the bond. Assuming the bond issuer makes good on their payments, the investor’s loan will be paid back through the scheduled interest payments as well as the return of principal at maturity.

This is a much less volatile way to employ one’s cash as compared with investing in a stock, which can have a very large range of possible outcomes over a period of a few years or less.

If your marginal income tax rate is high, another option to consider is that of Treasuries, which are only subject to federal tax but not to state or local tax.

To encourage investment in local projects, municipal bonds are usually free from federal tax and, under certain circumstances such as being a resident of the issuing state, from state taxes as well.

There are two types of municipal bonds:

• General obligation bonds
• Revenue bonds

General obligation bonds are backed by the taxing power of the issuer, and the project that it funds does not produce the income needed to pay off the bond.

Revenue bonds, on the other hand, fund projects which are intended to pay for themselves, using the income generated from the success of the project (think toll roads, for example) to pay off the bond rather than the utilization of taxes.

Treasuries and municipal bonds may meet an investor’s goals who desires to have reduced volatility while also keeping income taxation to a minimum.

Corporate bonds, on the other hand, with be taxable on the interest they produce. They don’t have the benefit of being able to tax or print money, so they will naturally offer higher interest payments than Treasuries to account for the risk (however small) of default.

Capital Gains: Purpose, Taxation and Pricing

A capital gain is realized (and therefore subject to taxation) when an asset such as an equity, bond, or fund is sold at a higher price than that at which it was purchased. 

This can be classified as either a long-term or short-term gain.

A long-term gain, which is defined by the sale of an asset which was held for longer than twelve months, generates the more favorable tax rate (tiers of 0%, 15% and 20%).

Remember that this is the exact same tax tier structure as that of qualified dividends.

A short-term gain, with the sale of an asset held less than twelve months, is subject to one’s marginal income tax rate. This discourages short-term speculation in the stock market, which is a small help toward the reduction of volatility across the stock market in general.

Again, remember that ordinary dividends (due usually to short-term trading) are also taxed at the marginal income tax rate.

A company’s value can improve for a number of reasons, but the main determinant of a stock’s value is the present value of the likeliest combination of future earnings. Whenever that potential for future earnings appears to improve, either through an increase in efficiency, a new good or service, a synergetic merger with a larger entity, or something else, the stock value can improve if this was a surprise to the general sentiment of public opinion.

When a company focuses on investing its retained earnings toward future growth of the company, its shares are often classified as “growth stocks” which usually trade at a higher price as compared with current earnings, because their focus is fully on generating greater returns in the future rather than paying out present earnings to the shareholders as dividends.

Whether one chooses to sell shares to free up cash, or whether they prefer to rely on the payout of dividends from a company, is really up to the preference of the individual.

There is not a right or wrong answer.

Both have similar tax structures in the US to make one indifferent between the two options.

The main thing to consider here is what your intention is. If you are focused on absolute return of your portfolio, dividends are not something that comes into significant consideration. If you are focused more on certain types of stocks that tend to pay dividends, or if you simply prefer the peace of mind knowing that a company is choosing to pay out to shareholders, then you may choose to include dividends in your consideration of a stock or fund.

Conclusion

The creation of income through the various methods is certainly worthy of consideration, firstly due to differences or similarities in taxation but also due to the nature of how that income is produced.

For retirees, a huge advantage to drawing from a retirement account such as a 401(k), 403(b), IRA or the Roth equivalent of these, is that income, dividends and capital gains are not subject to tax in such accounts. Income tax will apply from traditional (not Roth) retirement accounts, but the positive thing in this circumstance is that one can remain indifferent to the method in which they earn the income.

If you’re unsure or want a professional opinion about your personal situation, it is generally a good practice to consult a financial advisor or accountant to determine the optimal structure of your portfolio.

Here are a few things to remember:

• All things being equal, an investor interested in absolute return should be indifferent between a stock that pays a dividend and one that does not.
• In most cases, interest will be taxed at a higher rate than capital gains or dividends unless you take advantage of municipal bonds.
• Though taxes are important considerations, you should also consider your capacity and willingness to take on risk. Though interest is usually taxed at the marginal income rate, bonds have generally been much less volatile, and more predictable, than stock prices and dividends over shorter timeframes.

Now that you know how dividends, interest and capital gains differ in their unique aspects, it’s time to ask yourself a few questions:

• Are you investing in an account that qualifies for tax benefits, such as a 401(k) or IRA?
• If not, are you more interested in the lower volatility that bonds can provide, even though they are subject to higher tax than long-term capital gains in most cases?
• Do you simply like the idea of receiving a regular dividend from a stock?
• Is there a reason that you need to create income (dividends/interest) instead of focusing on absolute return? This could be the case for certain trusts that allow only income to be drawn by the beneficiaries.

These answers will differ from one person to the next. But with the tools of knowledge offered above, you can now chart your course more clearly toward financial freedom through these three types of passive income!