Investing in dividend-paying stocks is a good way to maximize the growth of your investment portfolio, hedge against difficult economic times and provide long-term income.
If you want to secure your golden years, unlocking the power of dividends is the smart play, but how do you build a good portfolio?
How to Invest in Dividend Stocks for Retirement
For investors seeking income in retirement, it’s generally a good idea to invest in stocks that offer relatively high dividend yields. The current average yield of the S&P 500 is 1.66 percent, but several stocks offer safe, reliable dividends of 3-4 percent. The higher a stock’s yield is, the more income you will be able to realize from it.
Investing $10,000 in a stock that yields 1.5 percent, for instance, will generate $150 in dividends annually. The same $10,000 invested in a stock yielding 3.5 percent will produce $350.
In addition to pure yield, it’s also important to consider the rate of dividend growth a stock offers. Dividends that grow over time allow you to increase your yield on cost and realize larger annual returns on your initial investment.
An incredible example of the power of dividend growth is Warren Buffett’s famous investment in Coca-Cola.
When the Oracle of Omaha bought the stock, his cost basis was about $3.25 per share. Given the company’s current annual dividend of $1.84 per share, Buffett’s dividend yield on his initial investment today is nearly 57 percent.
As an example of how dividend growth plays out, consider two stocks that trade at the same price and both pay $1 in annual dividends today.
Suppose the first stock increases its dividend at an annual rate of 3 percent, while the other achieves 6 percent annual growth. In 10 years, the first stock will pay $1.34 The second stock, however, will pay $1.79, providing much more income for the same initial investment.
Do Dividends Really Make a Difference?
One crucial point in building a dividend stock portfolio is to begin as early as possible. This will give dividend growth more time to bolster your yield on cost while also boosting the total returns from your portfolio.
Since 1945, dividends have contributed roughly one-third of the S&P 500’s total overall return. As such, investing in dividend-paying stocks is a strategy that can benefit younger investors, not just those who are already close to retirement.
Another consideration for investors is the frequency of dividend payouts. The vast majority of stocks pay dividends quarterly, making for four payments a year. Some, however, provide a more regular form of income by offering monthly distributions.
Many of the stocks following this model are real estate investment trusts (REITs), including the extremely popular Realty Income trust. Allocating some of your portfolio to monthly dividend producers may make it easier to manage your income and expenses in retirement.
A final key point in selecting dividend stocks is to consider the stock’s dividend payout ratio, which is the ratio of the annual dividend to the company’s earnings per share. The lower this ratio is, the more likely the stock’s dividend is to be safe and sustainable.
A lower ratio also gives management more room to increase the stock’s dividend if the company has additional cash it cannot invest productively in its business. Generally speaking, payout ratios of around 40 percent have offered a high degree of historical safety.
The Best Dividend Stocks to Buy for Retirement
Beyond the time-tested dividend aristocrats, investors may also choose to buy specific stocks for their high yields, growth potential or some combination of the two.
A good example of such a stock at the time of this writing is Microsoft. While the stock’s yield is tiny at just 0.8 percent, it has increased at a rate of over 10 percent annually during the past three years.
Investors seeking dividend growth from a company that is in a good position to distribute more cash to shareholders, therefore, may find Microsoft appealing.
Investors who aren’t comfortable selecting individual stocks can still benefit from the power of dividends using dividend-focused ETFs. These funds offer high dividend yields while also providing a degree of automatic diversification.
Two of the top funds in this category are the Vanguard High Dividend Yield ETF (VYM) and Vanguard International High Dividend Yield ETF (VYMI).
How to Build a Dividend Portfolio That Will Last
Arguably the most important key to building lasting income from dividends is to avoid stocks that offer unreasonably high yields. While these stocks may look attractive at first glance, they often carry higher risks than their more conservative peers.
Stocks with excessively high yields have typically experienced steep price declines as a result of financial difficulties or market stresses. Companies that pay extremely high dividends may also have difficulty maintaining their payouts over time.
Investors can also focus on specific industries that offer long-term stability and reliable cash flows. Some of the best industries for dividend stability are finance, utilities and consumer staples. These industries tend to perform well in both bullish and bearish market conditions, making them good places for investors to look for consistent dividend stocks.
A final key to protecting your dividend portfolio over time is to invest in companies with long histories of raising their dividends regularly. Here again, the S&P 500 dividend aristocrats have much to offer in this area. Companies that have increased their dividends over several decades are more likely to continue than those that have only recently begun paying dividends.
How to Protect Your Dividend Income From Taxes in Retirement
In addition to providing regular income in retirement, dividends can also offer substantial tax advantages.
Most dividends paid by publicly traded companies are considered qualified dividends, which the IRS taxes as capital gains instead of traditional income.
Qualified dividends are taxed between 0 and 20 percent, depending on your income level. It should be noted, however, that some dividends are taxed as ordinary income. Dividends from REITs, for example, are taxed at the normal income tax rate.
Because dividends can be taxed as low as 0 percent, investors can earn a substantial living from their distributions on a tax-free basis.
In 2022, for instance, single filers could earn up to $41,675 from dividends before being taxed. That number doubles for married couples who file their taxes jointly.
Even when qualified dividends are taxed, the rates are either 15 or 20 percent. This makes dividends an extremely tax-efficient form of retirement income.
How to Choose a Dividend Reinvestment Plan (DRIP) for Retirement
One of the best ways to build dividend income over time is through dividend reinvestment. In a dividend reinvestment plan, payouts are used to purchase additional shares of the stock.
These shares, in turn, can grow and produce dividends of their own. This allows for additional compounding over time, eventually producing larger and larger streams of dividend income.
Many companies offer their own DRIPs, allowing you to purchase shares and reinvest the dividends directly. These DRIPs sometimes offer discounted rates on the stocks, increasing both yield and total return over time. The downside, however, is that in-house DRIPs can only be used to purchase shares in the companies that operate them.
Fortunately, many brokerages now offer reinvestment options for all dividend-paying stocks traded through their platforms. These plans offer much more flexibility, but the stocks must be purchased at the full market price.
How to Trade Dividend Stocks for Retirement
Because dividend investing focuses on long-term income and growth, short-term trading has limited potential in building dividend income for retirement.
One short-term strategy does, however, apply specifically to dividend stocks. This strategy, known as dividend capture, involves buying a stock, holding just long enough to receive a dividend and then selling immediately.
Because stocks tend to fall somewhat after a dividend is announced, however, this strategy produces mixed results at best.
Risks of Investing in Dividend Stocks for Retirement
For all of their benefits, dividend-paying stocks still carry risks that investors should be aware of. Chief among these is the risk that business conditions will force a company to cut or even eliminate its dividend. If this occurs, investors can be left without much-needed income from their portfolios.
This is one of the many reasons that diversification is important in dividend investing. Even if one company cuts its dividend, it’s fairly unlikely that several companies across different sectors will all have to reduce their payouts simultaneously.
As with all stocks, dividend stocks are also subject to the risk of market volatility. As noted above, however, dividends can add considerably to the total returns of a stock portfolio over time. Dividend stocks also tend to be somewhat less volatile than high-growth stocks, making them historically good assets to hold during market downturns.
Finally, dividend stocks may suffer due to fluctuations in interest rates. At times when interest rates are high, the yields offered by stocks may be far less attractive than when interest rates are near zero. This can lead to selloffs as investors choose guaranteed income from bonds or high-interest savings accounts over the riskier option of stock market investing.
How to Make the Most of Your Dividend Portfolio in Retirement
Making the most of your dividend portfolio in retirement largely comes down to managing your expenses. If you can keep your expenses low, you may be able to provide for most or even all of them with tax-advantaged dividend income.
If you have other sources of income, you can also continue to reinvest part of your dividend income to keep your portfolio growing. This can be a good way to provide larger future income streams for yourself later in retirement. Continuing to reinvest also gives you the chance for further equity growth, allowing your portfolio’s principal to increase.
As with any other portfolio, it’s also important to periodically rebalance your dividend portfolio. Doing so can help you keep an eye on your portfolio’s performance and ensure that your dividend-paying stocks are still solid investments for the long haul.
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