Retirees used to rely on bonds for income. Their regular interest payments were dependable, and for many people that was enough. But with retirements now commonly lasting 25 or 30 years, income investors also need their savings to keep up with inflation. That means owning some investments that pay income today and have the potential to grow in value and income over time.
Dividend-paying stocks are one of the most widely used ways to do that. Here is why I think they deserve a place in many income portfolios, along with the risks to keep in mind.
Why dividends matter
- A sign of financial health. A company that pays a steady dividend is showing confidence in its future cash flow. A long record of paying, and especially raising, dividends often signals a mature, financially disciplined business.
- A major part of total return. Over long periods, reinvested dividends have accounted for a meaningful share of the stock market’s total return. The longer dividends are reinvested, the wider the gap between price return alone and total return.
- A potential cushion in down markets. Dividends keep coming in even when stock prices fall, which can soften the impact of a decline. Companies with a long history of increasing their dividends have historically tended to be less volatile than the market as a whole, although past performance is no guarantee of future results.
- Favorable tax treatment. Qualified dividends are taxed at 0%, 15%, or 20% depending on your income, plus the 3.8% net investment income tax for higher earners. That is lower than the top 37% rate on ordinary income such as bond interest.
- Diversified income. Stocks with above-average dividend yields can complement bonds and add another source of income that behaves differently when conditions in the bond market change.
The risks
Dividend-paying stocks are still stocks. They carry more risk than bonds, including the possibility of losing principal. A company can reduce or eliminate its dividend at any time without notice. And a very high yield can be a warning sign rather than a bargain, since some companies raise dividends to attract investors even when their finances are shaky, and a yield can look high simply because the stock price has fallen.
That’s why it pays to look at the quality of the business, how much of its earnings it pays out, and how consistent its dividend history has been, rather than chasing the highest yield. Many investors get dividend exposure through diversified funds rather than individual stocks for this reason.
Where you hold dividend stocks also matters. See Five Strategies for Tax Efficient Investing for how account location can reduce the tax on your investment income. If you’d like to talk about whether dividend-paying stocks fit your retirement income plan, please reach out.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
