If you’re investing for retirement for the long-term with an eye on increasing your income streams, dividend stocks may be the answer.
“Dividend investments have become desirable for retirees in the past six years, with declining interest rates and a choppy stock market,” says Nicholas Yrizarry, CEO of Yrizarry Wealth Management Group in Laguna Beach, California.
Yrizarry chalks up dividend stocks’ appeal largely to their ability to provide steady income while being less volatile than other securities.
Regardless of whether you have decades to go before retirement or you’re already enjoying your golden years, dividend stocks can be a powerful way to bolster your portfolio. Recognizing how to use them to your advantage while avoiding certain pitfalls is key to making the most of these investments.
Don’t try to rush results. If trading in and out of stocks is part of your investing style, dividend stocks may be a mismatch, advises Douglas Carey, owner and founder of Boulder-based WealthTrace.
“Investing in dividend payers is a long-run strategy for retirement,” he says.
[See: 7 Dividend Stocks to Buy That Pay More Each Year.]
In terms of the time horizon involved, the longer you have to save and invest, the better, particularly if you’re concerned about market volatility.
Kirk Chisholm, a wealth manager with Innovative Advisory Group in Lexington, Massachusetts, says dividend stocks are better suited to value investors who are looking to grow their capital over time.
“If you look at the historical returns that dividends provide compared to price gains, you might be surprised to learn that dividends produce more of the total returns than just price gains alone,” Chisholm says.
Do understand what you’re investing in. Choosing dividend stocks isn’t something you can guess at, says Mike Serio, regional chief investment officer for Wells Fargo Private Bank in Denver.
“Investors shouldn’t just blindly go into high dividend stocks,” Serio says.
The reason? Many of them are utilities, which can sometimes offer a low dividend growth rate. Serio recommends looking for companies that not only pay dividends but have a potential to increase those payments.
He also urges investors to examine whether a company’s dividend payout structure is sustainable. “Companies might be issuing stock or selling off assets to fund dividend payments, which is not a strategy that can be carried out long-term,” Serio says.
If you’re betting on a particular dividend stock to fund your retirement and the company’s underlying strategy proves to be faulty, the end result is that any income you’re expecting could dry up without warning.
Investors also need to be aware of the risk involved, particularly when investing in dividends for retirement, says Jason Lina, a lead advisor with Atlanta-based Resource Planning Group.
“Investors think dividend stocks are safer,” Lina says, when the reality is, they’re not.
He says what often happens when investors opt for a dividend-centric portfolio is that they have a collection of stocks in the same sectors that are highly correlated and more exposed to a rise in interest rates.
“In many cases, you end up with slow-growth companies that have nothing better to do with the cash than return it to shareholders,” Lina says.
[See: 20 Awesome Dividend Stocks for Guaranteed Income.]
Don’t focus solely on dividend yield. Dividend yield is an important consideration when choosing dividend stocks but it’s just one piece of a larger puzzle.
Charles Scott, founder of Pelleton Capital Management in Scottsdale, Arizona, says the biggest mistake investors make is being too enamored with the dividend being paid out. Instead, they should be paying attention to the underlying price of the stock itself.
“There’s not much point in getting a 5 percent annual dividend yield if the stock is going down 8 percent that same year,” Scott says.
He says investors need to remember that the dividend yield percentage is a function of the price of the stock. When the same dividend is paid each quarter, that causes the yield percent to increase if the stock price goes down.
David Twibell, president of Englewood, Colorado-based Custom Portfolio Group, cites what happened with energy stocks earlier in 2016 as an example of how being dazzled by dividend yield can be harmful to investors’ retirement goals.
“Because their share prices declined so rapidly, many energy companies had dividend yields of 5 percent or higher,” Twibell says. “If you looked under the hood, it was apparent most of them would have to reduce their dividends drastically in the near future to alleviate massive cash flow problems.”
The end result for investors who purchased these stocks based on their anticipated dividend yield was a double whammy. Dividends disappeared and share prices fell as a result of the dividend cut.
To avoid that kind of scenario, Twibell suggests that investors expand their focus to include not only yield but dividend growth, payout ratio and earnings growth when evaluating dividend investments. Together, they can give you a more complete picture of how likely a particular stock is to enhance your retirement portfolio.
Do factor in the tax implications of dividend investments. One of the most important things to factor in with dividend stocks is how they’ll affect your tax situation, says Hampton Bourne, a financial advisor with First Advantage Investments in Clarksville, Tennessee.
Bourne points out that investing in dividend stocks of foreign companies can trigger foreign taxes, as can dividend investments in master limited partnerships.
“Dividends have favorable tax rates when compared to earned income, but if tax management is important, investors should be careful,” Bourne says.
Dividends are taxable in the year they’re received, regardless of whether you cash them out or reinvest them in additional shares of stock. Qualified dividends are taxed the same as capital gains, with the maximum tax rate topping out at 20 percent. Non-qualified dividends, on the other hand, are taxed as ordinary income.
Holding dividend stocks in an individual retirement account can allow you to defer taxes until you retire. Alternately, you could enjoy tax-free growth if you’re investing in a Roth IRA.
Whether you invest in dividend stocks through a taxable or nontaxable account is critical to your tax outlook, both in the short- and long-term.
“If someone owns dividend stocks outside of a qualified plan, they must be prepared to pay taxes at ordinary income tax rates,” Yrizarry says.
Yrizarry says that there are some qualified dividends that are taxed at 15 percent but they may not be a company you’d want to own have a desirable yield.
[Read: How to Choose the Best Dividend Stocks.]
Looking at what you estimate your income will be at retirement can help you decide where to put dividend investments so taxes aren’t taking too large a bite out of your returns.
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Do’s and Don’ts of Dividend Investing for Retirement originally appeared on usnews.com
