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Note: The examples and case studies in this article are hypothetical but represent real situations I have encountered in my practice working with Washington State public employees. I was reviewing a portfolio for a county employee, 24 years in PERS Plan 2. Nearly every holding was a high-dividend stock or fund. AT&T. Verizon. A couple of utility companies. And a variety of mutual funds. Her pension alone will cover most of her essential expenses in retirement. And yet, she had built her entire investment portfolio around generating dividend income. "I just want my investments to replace my paycheck when I retire." I hear this all the time. For 25 or 30 years, your paycheck just showed up. Then one day, it stops. According to a recent Schroders survey, 87% of non-retired Americans are concerned about how to generate income once they stop working.⁶ Dividends feel like they solve that problem. But here's what I've learned working with Washington State public employees: you already have a paycheck replacement. It's called your pension. And that changes everything about how your portfolio should be built. The birthday cake problem A dividend isn't extra money being created out of thin air. It's a portion of the company's value being removed and handed to you. Think of it like slicing a piece of birthday cake and putting it on a separate plate. You didn't create more cake. You just moved it. Research from Dimensional Fund Advisors confirms this. They examined the 10 largest companies in the S&P 500 High Dividend Index over 20 quarterly dividends each. The average dividend was $1.00 per share, and the average price decline on those ex-dates was $1.15.⁷ If you reinvest that dividend, nothing really changes. But most retirees aren't reinvesting. They're spending those dividends. And that's where the tax problem begins. The tax drag nobody talks about Here's the part that hits home for me as a CPA. Every time a dividend shows up in a taxable brokerage account, the IRS sees income. You owe taxes on it that year, whether you need the money or not.¹ Qualified dividends are taxed at capital gains rates (0% to 20%). Ordinary dividends get taxed at your regular income rate.² You don't control the timing. The company pays the dividend, it hits your tax return, and you pay the bill. A Cambria Investments study found that a top-100 dividend yield strategy returned roughly 14% annually before taxes from 1974 to 2022. At the highest tax bracket, after-tax returns dropped to about 8.6%.⁸ Tax drag compounds. Every dollar that goes to taxes is a dollar that can't grow for you over the next 20 or 30 years of retirement. Now, some of you might be thinking: most of my money is in my DCP or an IRA. Dividends aren't taxed inside those accounts, so this doesn't apply to me. The annual tax drag doesn't hit you the same way inside a tax-deferred account. But if you're selecting funds based primarily on which ones pay the highest dividends, you may be owning slower-growing, lower-quality companies without realizing it. A big dividend doesn't automatically mean it's a strong company. The Cambria study found that a straightforward value approach outperformed the high-dividend strategy even before accounting for taxes.⁸ Why this matters even more for Washington State public employees As a PERS, TRS, LEOFF, or SERS member, you're going to have multiple income sources on your tax return in retirement: your DRS pension, Social Security, DCP withdrawals, and investment income.³ Add uncontrolled dividend income on top of that. Those dividends could push you into a higher tax bracket, increase how much of your Social Security becomes taxable, and trigger higher Medicare premiums through IRMAA.⁴ You don't get a say in any of that if your portfolio is generating dividends on its own schedule. "I just spend whatever my portfolio pays out" I hear this one a lot too. Some people tell me they just live off whatever dividends and interest their portfolio generates, so they never have to worry about withdrawal strategies or selling anything. But here's the thing. When your income is determined by what your portfolio happens to distribute rather than what your retirement plan actually calls for, you've handed the controls over to a dividend schedule that knows nothing about your goals, your spending needs, or what's happening in the rest of your financial life. Maybe you need more income one year because of a big expense. Maybe you need less. Maybe your tax situation changes. The dividend schedule doesn't care. It pays what it pays, the tax bill follows, and you deal with the consequences. That's not a plan. That's just reacting. What actually works better A total return approach puts your retirement plan back in the driver's seat. Instead of relying on whatever income your portfolio happens to generate, you build a diversified portfolio and withdraw strategically based on what your plan actually calls for. Your pension is your paycheck. Your DRS pension already provides the stable, predictable income that dividends try to replicate. Your portfolio doesn't need to duplicate what the pension already does. You decide when to create income. You choose when to sell, how much to take, and which account to pull from. You can coordinate withdrawals around your tax bracket, Social Security, and Medicare premiums. Your DCP gives you built-in tax flexibility. Washington's DCP now offers both pretax and Roth options.⁵ You can pull from either depending on what makes the most tax sense in any given year. A war chest of bonds handles volatility. Keep several years of withdrawals in high-quality, short-duration bonds. When stocks drop, spend from bonds. When they recover, replenish. You can use the tax code to your advantage. This is the part that gets me excited as a CPA. With a total return approach, you might intentionally realize some capital gains in years where your taxable income is low enough to fall within the 0% long-term capital gains bracket. ² That means in the right year, you could sell appreciated investments and owe zero federal tax on the gain. You can't do that when dividends are forcing income onto your tax return whether you want it or not. The piece most people miss Dividend investing feels safe. It feels like you're not touching your principal. But you are. The same Cambria study found that a simple value strategy excluding the top 25% of dividend payers outperformed the high-dividend strategy on both a pre-tax and after-tax basis.⁸ The value premium did the heavy lifting. The dividend just came with a tax cost. There are simpler, more tax-efficient ways to get that same exposure without generating unnecessary taxable income. So if the math is this clear, why do so many retirees still build their portfolios around dividends? The Cambria researchers use a great analogy. Back in 1975, Pepsi ran blind taste tests. Over and over, people chose Pepsi. But Coke kept outselling Pepsi by a wide margin. When researchers showed the labels before the taste test, preferences flipped. Most people chose Coke. The brand overpowered their own taste buds.⁸ Dividend investing works the same way. The brand of dividends (passive income, steady checks, never touching principal) creates such a powerful emotional pull that it often overrides what the data actually shows. Investors fall in love with the story, even when the math tells a different one. I'm not saying this to be harsh. I'm saying it because once you recognize that your instinct might be protecting a belief instead of evaluating evidence, you can step back and look at the numbers objectively. If you don't believe me, maybe you'll believe Warren Buffett Warren Buffett's Berkshire Hathaway has almost never paid a dividend. In fact, the company paid a single 10-cent dividend back in 1967. Buffett later joked that he must have been in the bathroom when that decision was made.⁸ Think about that. One of the greatest investors of all time runs an enormously profitable company and chooses not to distribute those profits through dividends. Why? Because Buffett has long believed that reinvesting earnings back into the business creates more value and higher after-tax returns for his shareholders than sending that money out as a taxable dividend. He'd rather keep the capital working inside the company, compounding for decades, than hand it to shareholders and let the IRS take a cut along the way. And the results speak for themselves. Berkshire's track record is so strong that even if the stock dropped 99% from its current price, it would still be ahead of the S&P 500 over its lifetime.9 That's the power of keeping capital invested and letting it compound, rather than pulling it out as dividends. And it's the same principle that applies when you're building your own retirement portfolio. Total return, not yield, is what determines how much wealth you actually build and sustain. What to do with this If you're a Washington State public employee approaching retirement, a few things worth considering. Look at your taxable brokerage account. Is it full of high-dividend funds chosen for yield? A total-return approach might serve you better from a tax standpoint. Think about what your pension already provides. If your DRS benefit covers core expenses, your portfolio has a different job. If you're still years from retirement, contribute to both pretax and Roth options in your DCP for more control later.⁵ And talk to someone who understands how the pieces fit together. Your pension, DCP, Social Security, and Medicare premiums are all connected. A portfolio built around dividends doesn't account for that coordination. The goal isn't to avoid every company that pays a dividend. It's to stop chasing yield and start focusing on what actually drives long-term retirement success: total return, tax efficiency, and a plan that puts you in control. Sources
-Seth Deal
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AuthorsBob Deal is a CPA with over 30 years of experience and been a financial planner for 25 years. Archives
April 2026
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