The Uncomfortable Truth About Dividend Investing: Tax Inefficiency and the Passive Income Illusion

🚨 Stop Saying "I'm a Dividend Investor"

I always hear people say, "I'm a dividend investor." But honestly, you need to get that out of your head.

What you need to focus on is: "Can I buy a good company?" Dividends, in my opinion, are the very last thing a company should do with its cash flow.

Today, I want to talk about some uncomfortable truths about dividends that many investors don't know or don't want to hear.

💸 What Companies Should Do Before Paying Dividends

There's a priority list for what companies should do with their cash flow:

Pay down debt - Ensure financial health
Buy back shares at cheap prices - Enhance shareholder value
Reinvest in the business for growth - Expand future earnings
Make intelligent acquisitions - Expand the business

All of these should come before paying dividends.

But people get obsessed with dividends. And there's a reason why companies pay them—they know people love them.

💰 The Tax Inefficiency of Dividends

Let me tell you why dividends aren't great. The first reason is tax inefficiency.

When you get a dividend, that's money the company already paid taxes on. The company got its profit, paid taxes, and now has money in its account. When they pay that out to you, it gets taxed again.

Let's Do the Math

A company earns $1 billion in profit
Pays 30% corporate tax → $700 million remains
Pays out all $700 million as dividends
Investors pay 30% tax → $210 million in taxes
Final amount in investors' hands: $490 million

From the original $1 billion, over 50% went to taxes!

If you owned a company with an LLC, you wouldn't pay two taxes. It would pass through to your income. But as a shareholder of a public company, you can't escape double taxation.

So when people say "dividends are low tax," I can't help but laugh.

🎭 The "Passive Income" Illusion

Another misconception is that dividends are passive income. They're not.

Yes, I get that you sit there and collect a check. But that's no different than saying, "I'm going to buy this ETF, sell it every year, realize the gain—that's passive income."

Just because you're realizing income doesn't make it real income. And it's not passive to me.

Why It's Not Passive

📚 You still have to understand what you're buying
🔍 You still have to do your homework
👀 You still have to stay on top of it

I actually don't believe in such a thing as passive income. There is no free lunch.

🤔 Why I'm Telling You This

This is exactly why I teach on YouTube. I see all these misconceptions from finance influencers on Twitter, Instagram, and YouTube, and I think to myself: "They don't get it."

I'm not going to be right about everything. But on this dividend thing—I'm probably right.

How do I verify that? When I joke with my other smart value investing friends and we talk about everybody's dividend investing, it gets a chuckle out of all of us. We think it's the most naive approach.

💎 It's Not That I Don't Like Dividends

Don't get me wrong. Dividends are awesome. Buffett loves dividends. I love dividends.

But if someone told me:

"Paul, I can take this billion dollars and reinvest it to get a 20% return."

To me, that's a much smarter decision than paying out dividends.

But the dividend investor only cares about one thing: "How do I get that dividend?"

🎯 SCHD Fits My Goals

I have SCHD because it fits my goals and what I want from that portion of my portfolio.

But remember:

🏢 I've got a thousand apartments
💼 I've got several businesses growing in value and generating cash flow
📊 Only 30% of my net worth can be invested in the stock market

So my portfolio isn't needed to get really high returns. It's to build stable money I can live off of, buy great companies at good prices, and buy low-cost ETFs like SCHD.

🚀 I Don't Need the Fastest Rocket to 10x Returns

I don't need the fastest rocket ship to 10x returns. What I want is:

✅ Income that outpaces safe options like 90-day treasuries
✅ Good companies that will pay me while I hold them

Right now, SCHD's dividend yield is better than what I can get from short-term treasuries. And unlike bonds, dividends can grow over time. That matters.

📌 Advice for Young Investors

When I see people on the internet who love dividends, they tend to be young people. And I think: "Really?"

You have the time to take on more risk in growth-heavy ETFs like QQQ. QQQ is heavy on growth and tech.

For someone investing over a 20, 30, 40-year horizon, having a piece of that great growth makes a lot of sense. But it comes with immense volatility.

Here's Something Amazing

Let's say you started investing in QQQ at the very peak of the dot-com bubble in March 2000. The market fell 80% from that peak. But if you just kept dollar cost averaging all the way down until today, your returns would be over 14.5% per year.

Hard to believe? But it's true.

If you're young and still saving, buying SCHD just for the dividend means you're giving up a lot of long-term potential. It could hurt you in the long run.

💡 Key Takeaways

🔴 Don't get obsessed with the "dividend investor" identity
🔴 Understand the tax inefficiency of dividends
🔴 Break free from the passive income illusion
🟢 Focus on buying good companies at good prices
🟢 Dividends are secondary, not the primary goal
🟢 Choose a strategy that fits your situation (age, assets, goals)

Dividends are great. But good companies come first. Don't reverse the order.