Currently Joseph Biden leads in the polls. One point of concern for Democratic voters is executive compensation and corporate share buybacks. Therefore, there is a good chance that Biden winning the election would result in restrictions on share buybacks.

What is a buyback? 

There are two ways for a corporation to return earnings to shareholders: buybacks and dividends.  Buybacks have been very popular in recent years. Buybacks mean fewer outstanding shares, so each shareholder gets a higher percentage of each dollar earned.

The problem is that buybacks also cause executive stock options to rise in price which is a big source of the narrative about executive compensation becoming excessive relative to workers who get few if any stock options.  As the political winds shift more towards social justice, we expect share buybacks to become increasingly untenable for corporations especially when they are often caught asking the government for favorable legislation or direct financial aid. Consequently, corporations will find increasing their dividend payout to be more sustainable and acceptable to their stakeholders.  McDonalds is an example of a company that ended share buybacks but still pays a dividend. This is also true of the 8 largest banks.

If buybacks go away but corporations still want to return free cash to their shareholders, it is likely they will do it by an increase in dividends. Currently, investors have earned 2.30% on buybacks which is greater than the 1.80% return to dividends. Might this relationship invert, resulting in higher income to investors? Now is a good time for investors to purchase shares that have lower dividend yield priced into them. This acts as a defensive measure to protect one’s participation in the rise of the market and as an offensive measure to position oneself for future gains.

Another factor investors should consider is that Biden will propose an increase to the capital gains tax rate, equaling the ordinary income tax rate. In this way we expect dividends will become more favorable relative to growth investing—which has been favored for the past decade.

There are many dividend focused funds, but these could be problematic for retirees because of tax.

Normally, we expect to get taxed once on our dividends.  But dividend funds usually generate extra taxable capital gains—which are out of the investor’s control. This would be fine if all fund holders got to realize the gain but, paradoxically they get none of it.  Only those who sold out derive the benefit. So, this may not be the most tax savvy way to access good dividend paying stocks.

For example, look at the Fidelity Equity Income Fund. Seemingly the 1.97% dividend yield tracks the S&P 500. However, you ALSO pay tax on the .57% capital gain distribution at a 30% federal and state tax rate. This lowers the dividend yield to 1.80%; adding in the expense ratio, the dividend yield becomes lower than the S&P 500’s.

ETFs are better but in a perfect world, you would hold these types of income heavy securities in your retirement account. Then, parsing the growth aspects of your portfolio into your taxable account; where it can take advantage of lower capital gains tax treatment as well as tax loss harvesting to reduce your bill—did you tax loss harvest during the Covid-19 downturn?

This brings us to how you hold onto your hard-earned income through asset location.

While pushing money into retirement plans is a good first measure, investors should also make efficient use of tax-free vehicles including 529 plans and more importantly, the Roth IRA.

A Roth conversion analysis is complex and varies with the particulars of the investor’s circumstance. We begin with an analysis, figuring out if it makes sense for the client. If so, we help our clients convert the funds, receiving the benefits of this very potent strategy.