Many investors put more emphasis on dividend-paying stocks as they get older and want steady income. Even younger investors may want to load up on top-quality dividend payers since even small dividends boost returns considerably over time.
But where should you put them — in an ordinary taxable account, 401(k), an IRA or Roth?
As with most financial matters, it depends. Are you using the income for expenses right away? Are you automatically reinvesting it for growth? What tax bracket are you in?
“Asset location is a strategy that is often overlooked by investors but it is important for investors who are seeking to maximize their after-tax returns,” say Kevin Nolan and Sean Flynn, financial advisors at Essex Connecticut-based Essex Financial, in a written response to questions.
[See: 7 of the Best Stocks to Buy for 2018.]
“Tax-deferred accounts [like traditional IRAs and 401(k)s] should hold the less tax-efficient investments, and your taxable accounts should hold your [tax-efficient] ETF’s, index funds, dividend paying stocks and municipal bonds,” they say.
As that indicates, it’s important to know how dividends are taxed in different accounts.
In a taxable account, they are taxed at a rate that applies to dividends and long-term capital gains. That’s zero or 15 percent for most investors, 20 percent for those with big incomes, such as $479,000 or more for a married couple filing a joint return. Most importantly, dividends are taxed in the year they are received. If some of that income is used for taxes, less is left for expenses or to grow if reinvested.
In a traditional IRA, traditional 401(k) or similar tax-favored account, dividends are not taxed the year received. That leaves more to compound over the years that follow. But when money is withdrawn, usually after age 59½, it is taxed as ordinary income. That rate can be anywhere from 10 percent to 37 percent depending on the investor’s income. In most cases it will be higher than the dividend rate for a taxable account.
In a Roth IRA or Roth 401(k), dividends are not taxed at all. That obviously boosts compounding during the investment years, and provides tax-free income when withdrawals are made after 59½. But converting to a Roth from a traditional IRA or 401(k) can involve a hefty tax bill, as income rates apply to converted sums that have not been taxed before.
“For aging individuals, these types of investments are best held in a Roth account,” Nisa Khan, president of IEM Asset Management in Red Bank, New Jersey, says.
Unfortunately, many investors don’t qualify to open a Roth account, which is limited to singles earning less than $120,000 and a couple filing joint returns making under $189,000.
But anyone can convert a traditional IRA or 401(k) into a Roth by filling out a form and paying taxes on the converted sum. That would include investment gains in the old account plus all tax-deductible contributions made over the years. Most likely to benefit are investors expecting to be in a higher income-tax bracket in the future. For them, paying a conversion tax today would mean avoiding a higher tax rate later.
“If you don’t have a Roth account and cannot contribute, consider converting a certain amount from your 401(k) or traditional IRA to a Roth account systematically over time,” Kahn says. “This allows having all dividends, interest, and capital gains be tax-free.”
[See: 11 Steps to Make a Million With Your 401(k).]
Taxable accounts can have a role for dividend-oriented investors, too, since earnings are taxed at the lower dividend rate instead of the income-tax rate for IRAs and 401(k)s, according to Matt Ahrens, an advisor with Integrity Advisory in Overland Park, Kansas.
“For current retirees, I like to use taxable accounts to provide income now,” he says, though he agrees that a Roth works well for the investor with a longer time horizon.
Protecting dividend income from annual taxes can be especially important for younger investors seeking long-term growth, because dividends should be reinvested rather than spent, Nolan and Flynn say. Dividend yields may seem small but have a big effect on compounding, as more and more of the holding is due to dividend reinvestment over time.
“If you invested $10,000 in December of 1960 and you reinvested the dividends through December of 2016, your portfolio would have grown to over $2.1 million,” they say. “Compare this scenario to the investor who spent the dividends each year and the portfolio would have grown to $385,000 over the same period.”
With decades of investing ahead before you intend to take money out, a Roth account would likely be the best option, and after that a traditional IRA or 401(k) with tax deferral, rather than a taxable account that would cost you every year.
Of course, fixating on dividends is not a sure winner. Plenty of non-payers have provided stellar returns through share-price growth.
“One plus side to using dividend-paying stocks is they often increase their payout once a year, and this helps keep up with inflation,” Ahrens says. “One downside is that in a severe market downturn many companies reduce or turn off their dividend to protect their cash in lean years.”
General Electric Co. (ticker: GE), he says, startled investors by slashing its dividend in half last year.
[See: 7 Dividend Stocks Yielding 7 Percent and More.]
“This only further validates the need for diversification not only amongst other dividend paying companies, but also from other sources of income like bonds or simply harvesting gains in the portfolio,” Ahrens says.
More from U.S. News
7 of the Best Dividend Stocks to Buy for 2018
Why Investors Love Legacy Companies
10 Investing Themes to Remember for 2018
Consider the Tax Rate on Your Investments originally appeared on usnews.com
