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Double taxation

Q: Are stock dividends really taxed twice?

A. Yes, indeed they are.

To understand how, imagine that the Tattoo Advertising Co. (ticker: YOWCH) generates $100 million in sales, and after subtracting various expenses, keeps $20 million, which gets taxed. The U.S. federal corporate-tax rate has recently been 35 percent and was reduced to 21 percent starting in 2018. Many companies shield much of their income, with some paying an effective rate in the single digits — or lower!

Tattoo Advertising can do many things with its post-tax earnings. It can buy more equipment, hire more workers, pay dividends to shareholders, buy back and retire some of its own shares (which boosts the value of remaining shares) and so on. Any dividends it pays, though, are generally considered taxable income for shareholders. That’s how dividends get taxed twice.

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The double taxation is why some investors prefer to see a company using its money to build more value for shareholders without paying out dividends. It’s also why some companies opt to repurchase shares, rewarding shareholders in a tax-free way. Repurchasing shares is wasteful, though, when a stock is overpriced.

Q: Where does the money go when a stock falls in value?

A: No one necessarily gains directly when a company’s stock price drops.

Imagine you own shares of Porcine Aviation (ticker: PGSFLY) and its shares drop 10 percent one day. You haven’t technically lost any money, unless you sell the stock. (After all, they could rebound.) The shares are less valuable, though, because the market views them as less valuable due to some development or news. A stock’s price typically just reflects the last price someone was willing to pay for it.

MY DUMBEST MISTAKE

Hurt by frequent trading

Dear Fool: Years ago, a co-worker came into my office with a marvelous story of how he was making lots of money with an investment adviser who was buying and selling stocks for him. Not long after, I sent this “adviser” my money, and he assured me he was investing it to make me rich.

I later discovered the adviser was just trading frequently and racking up some very high brokerage fees. I didn’t even know what investing on margin was, but he had me doing it, and soon I was getting notices that my stocks were being sold to cover losses as various stocks were going down.

It was a very expensive lesson. I learned there are questionable advisers who don’t have your best interest in mind. I also learned that the No. 1 person with your best interest at heart is you, and not to invest in anything you don’t understand.

The Fool responds: Some financial professionals do have conflicts of interest, such as if they’re compensated for selling you on certain investments. Others may simply not be skilled investors.

Many investors without much confidence in their holdings will jump in and out of them every time they run across new and exciting investments. Such frequent trading will rack up commission costs — and can boost your tax bill, too.

Some advisers are great, however, though being in charge of your own money is smart, too.

THE MOTLEY FOOL TaKe

Dollars and Cents From Tencent

If you’re looking for stocks that have huge growth potential, the Chinese tech sector is a great starting point. One of the world’s fastest-growing economies, China features an expanding middle class and increasing internet engagement.

A particularly appealing Chinese tech stock is Tencent Holdings (Nasdaq: TCEHY).

It’s the largest video-game publisher worldwide, generating more than $10 billion in revenue from games last year. Hit titles such as “League of Legends” are racking up hundreds of millions of monthly active users and demonstrating longevity that’s the envy of competitors.

Its “Honor of Kings” is China’s most popular mobile game — and perhaps the most-played video game in the world.

Tencent is positioned to be one of the biggest beneficiaries of industry growth, and its combination of gaming and social-media businesses (WeChat) makes it an early power player in esports — competitive multiplayer video-game playing.

The tech giant’s growth opportunities in categories such as e-commerce, ride hailing, cloud services and online payment processing make it well worth considering for the long-term portfolios of risk-tolerant investors. (The Motley Fool owns shares of and has recommended Tencent Holdings.)