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Thursday, September 5, 2013 - 11:30
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Thursday, September 5, 2013 - 11:30

Dividends Are Great... But 'Tax-Free' Dividends Are Better

Thursday, September 05, 2013 11:30 AM

They're on fire this year.

Right now, top companies -- from IBM (NYSE: IBM) to Intel (Nasdaq: INTC) -- are giving shareholders more bang for their investment buck with a special kind of "dividend." But unlike dividends, these are completely tax-free.

Before I tell you what I am talking about, I have a simple question for you...

If you could buy 5% of a company and have it turn into 10% of the business -- without investing another dime -- would you do it?

It's obviously a rhetorical question. Who wouldn't want their stake in a company to double in size?

Well, it so happens that you can do this.

I'm talking about companies buying back shares of their own stock. And like I said, they're on fire...

In the past 12 months, the 1,000 largest U.S. companies -- as represented by the Russell 1000 Index -- have bought back a stunning $455 billion of their own shares. That's up 32% from the prior 12-month period. Still, if you go back to 2009, companies have spent $1.4 trillion buying back their own stock.

So how do buybacks reward investors?

Think back to Econ 101. The payoff is largely a function of the law of supply and demand.

To keep things simple, imagine you own one share of a company that has 10 shares outstanding. You would own 10% of the company. Now, let's say the company bought back five of the 10 outstanding shares. You would then own one of five outstanding shares, or 20% of the company.

Your ownership has doubled, but you don't have to pay taxes on the increase. And as long as the company's value remains unchanged, each share of stock is twice as valuable.

How can companies afford to buy back so much of their own stock?

At the end of last year, U.S. corporations were holding nearly $1.8 trillion in cash, a figure that has grown by 70% in the past 10 years. And now, companies are returning that capital back to shareholders through dividends and buybacks.

In a way, buybacks are better than dividends...

I love to see dividends hit my account as much as the next investor. But in a regular brokerage account, dividends create a taxable event. Depending on where that cash was sourced from and your marginal tax rate, you could lose up to 39.6% of the dividend to Uncle Sam.

On the other hand, when a buyback happens, the tax man doesn't care. Instead, the value created by the buyback can continue to grow until you sell the shares. At that time you will only be responsible for the capital gains, which max out at 20% for investments held more than a year.

And buybacks can certainly drive gains...

Just check out the PowerShares Buyback Achievers ETF (NYSE: PKW), which invests in companies that have bought back at least 5% of their shares outstanding during the prior 12 months. This ETF has more than doubled the returns of the S&P 500 over the past five years.

Keep in mind that share buybacks don't necessarily guarantee that the share price will rise. Although they can give investors a larger piece of the pie, if the pie is shrinking, then the total value of your investment could decline.

But as a general rule, if you invest in companies with strong buyback programs, your shares are likely to increase over time as your stake in the business grows -- even if the company's actual business doesn't grow a cent.

P.S. --  Many companies that have a strong history of buying back stock could also be called "Forever Stocks." If you're not familiar with "Forever Stocks," the concept is simple... These are stocks you can buy, hold (practically) forever and watch as your stake in the company increases due to buybacks. And with dividends and capital appreciation, you'll handily outpace the market over time. In fact, stocks on our "10 Best Stocks to Hold Forever" list have returned up to 57%... 92%... even 180%. To learn more about "Forever Stocks" and to get access my free report, click here.

Elliott Gue does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of IBM, INTC in one or more of its “real money” portfolios.