Dividend stripping

Dividend stripping is a popular strategy among investors, especially in countries where dividend income is taxed at a higher rate than capital gains. Investors can balance capital losses against other capital gains income and earn tax-free dividends by purchasing and selling shares around the time of a dividend declaration. This strategy is especially effective for investors with significant dividend-paying stocks in their portfolios. 

What is dividend stripping?

Dividend stripping is a short-term trading method in which company shares are bought and sold around the time a dividend is declared. The technique is intended to capitalise on dividend income and capital loss tax advantages. The objective is to capitalise on dividend income while typically benefiting from tax advantages. This strategy takes advantage of the price adjustment after a dividend distribution, commonly employed to achieve a tax benefit or arbitrage opportunity. 

Understanding dividend stripping

Dividend stripping requires significant capital to be profitable, so institutional investors are the only ones who generally participate in it. They can purchase huge quantities of securities and mitigate risks. If one stock performs poorly, it might be offset by a more successful stock. 

Investors purchase stocks that are expected to declare dividends in the first phase to be eligible for the next distribution.  This time is crucial because it coincides with the ex-dividend date, the deadline for being declared qualified to receive the dividend. Investors who would instead make short-term investments rather than long-term ones frequently favour this technique. 

The shares are sold in the second phase, followed by the dividend payment. Usually, the stock prices fall after a dividend, reflecting the distribution. The investor’s objective is to sell the shares at a rate that, when added to the dividend income and even after considering this decline, still permits an overall profit. Although this approach has the potential to be profitable, there are drawbacks, including potential price volatility and tax implications. 

Mechanism of dividend stripping

Tax planning and short-term trading are two components of the dividend stripping mechanism. The key steps are as follows: 

• Buy shares 

An investor purchases a company’s shares before the dividend declaration date. This is usually done when a stock price increase is anticipated due to an upcoming dividend payment.  

• Dividend declaration 

After the dividend declaration, the investor becomes a shareholder and gets the dividend on the specified payment date. 

• Sell shares 

The investor sells the shares after the dividend declaration date, typically at a lower price due to the dividend payment. The objective is to sell at a rate in which, even after the decline, the combined value of dividend income and selling profits is either equal to or exceeds the break-even point, resulting in a profit. 

• Tax benefits 

The investor earns tax-free dividends and can offset the capital loss against other capital gains income. 

Benefits of dividend stripping

Dividend stripping offers several benefits to investors: 

• Tax efficiency method 

Since dividends are sometimes taxed at lower rates than capital gains, dividend stripping may be a very advantageous tax strategy. It’s a tax-efficient approach to create revenue. 

• Capital losses 

Investors can offset capital losses against other capital gains income, reducing their overall tax liability. 

• Short-term profit potential 

If done effectively, investors can benefit from the difference between the stock’s purchase price and the dividend received, mainly if the stock price does not fall by the dividend amount after the ex-dividend date. 

• Market insight advantage 

As a smart play on market timing, dividend stripping demands an awareness of market patterns and timings, particularly with regard to dividend declaration and payment dates. 

• Diversification mechanism 

While this is not a long-term growth strategy, it diversifies an investing portfolio by combining a steady stream of dividend-paying stocks with other investment options. 

• Price drop offset 

Although share prices typically fall after a dividend distribution, this technique seeks to counter the loss with dividend income, perhaps resulting in a balanced or positive conclusion. 

Examples of dividend stripping

Let’s understand dividend stripping with the following example:

Suppose you buy 100 shares of XYZ Inc. at US$50 per share before the dividend declaration date. The company declares a dividend of US$2 per share, which is paid to shareholders.  

After the dividend declaration date, you sell the shares at US$48 per share. You earn a tax-free dividend of US$ 200 and incur a capital loss of US$200.  

If you have other capital gains income, you can offset this loss against those gains, reducing your overall tax liability. 

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