For most people, the best way to save for retirement is to invest for a long period of time in a variety of assets according to a traditional asset allocation model.
One such portfolio could include distinct asset classes to achieve diversification as well as companies that pay dividends. Dividends can serve as income in retirement or as a hedge against market risks.
Read on to learn whether dividend-paying companies might be a good fit for your retirement investment strategy.
Key Takeaways
- When investors buy shares in a company, they’re entitled to a portion of the profits, which is represented by dividends.
- Dividends may be paid out at fixed rates for preferred shareholders or variable rates for common stock shareholders, and the payment is most commonly made on a quarterly basis.
- Dividend income can be used to hedge against volatility and inflation because it is usually steady and reliable.
- On the downside, companies can choose not to declare dividends, which can negate the benefit of diversifying a retirement portfolio with dividend-paying stocks.
- Dividend income is taxed at the ordinary income tax rate, which is usually higher than the capital gains tax rate.
How Dividends Work
Before deciding on a retirement investing approach that includes dividends, it is important to understand how dividends work.
When an investor purchases a stock, they become a proportional owner of a company based on how many shares of stock that they buy. Profits that the company makes may be shared with the shareholder in one of two ways:
- Dividends: A dividend is paid out on a per-share basis. If an investor owns 100 shares, and the company declares a $0.50 per share dividend, the investor receives a total dividend payout of $50.
- Capital appreciation: The company’s stock price may increase over time, making the shares owned by the investor more valuable.
Dividends are typically paid in cash on a quarterly basis and must be owned by the ex-dividend date in order to receive the declared dividend.
Shareholders who own preferred stocks receive fixed-rate dividends, while common stock shareholders receive variable-rate payouts.
Why Dividends for Retirement Investing?
Investors who favor a portfolio that provides them with income in retirement may wish to consider dividend-paying stocks as part of their asset allocation. Dividends offer various benefits for retirement investors:
- They are payments of cash that can supplement retirement income.
- They are payments made by companies with growth potential, which can mean your investment account may grow in value over time, while you receive dividend income.
- Companies that pay dividends are known as shareholder-friendly, which typically means that their goals line up with their investors’, and they’re focused on meeting them.
- Dividend-paying companies usually are financially healthy, mature companies that are run well and can withstand difficult markets or weakening economic environments.
Note
To invest in dividend-paying companies, you can choose to buy individual stocks of companies that pay them or to buy shares in a fund, such as an exchange-trade fund, that invests in a large selection of companies that pay them.
Advantages and Disadvantages of Dividends
Advantages
- In addition to the benefits described above, in general, dividend income can protect investors from poor investment performance and the potential loss of principal while they save for retirement.
- Equity investments may not provide the return consistency through capital appreciation that investors need to achieve retirement savings goals. Investing in dividend-paying stocks means potential capital appreciation plus income for what could be a higher total return.
- Although equity investments are attractive to investors for the opportunity for higher returns, price volatility can distress investors saving for and in retirement. Dividend stocks tend to be less volatile than other equities.
- Investors can use dividends to hedge against rising inflation for the long term. Inflation can have a corrosive effect on investment returns.
Disadvantages
- Dividends are not guaranteed so investors should not rely completely on consistent payouts. Doing so can affect investing outcomes. Should companies decide not to declare dividends, investors could fall short of their savings goals.
- Dividends usually are taxed at an investor’s ordinary income tax rate, while the gains associated with the sale of appreciated stock typically are taxed at the lower capital gains tax rate. Paying higher taxes can can have a negative effect on returns and may be difficult for those in retirement.
- Dividend income that’s not reinvested can reduce potential returns.
What Do Dividends Indicate About a Company’s Financial Health?
When a company decides to pay a dividend, typically it has the financial soundness to release some of its profit to investors. Otherwise, a company might reinvest all of its profit back into itself. A company that stops paying dividends may be in financial trouble.
How Do Dividends Provide Me With Income for Retirement?
For investors, dividends represent a share in the earnings of a company. While dividend payments can take different forms, it usually is a cash payment. Retirement investors with enough shares of one or more dividend-paying stocks will receive income payments quarterly that can be significant. Once deposited into their investment accounts, this income can be withdrawn and used as needed.
Is There a Risk to Dividends in Retirement?
Yes, there’s the risk that companies may decide not to pay them and a retiree may not receive enough income for their standard of living. Remember, dividends aren’t guaranteed, even though companies may have paid them for years.
The Bottom Line
Many people devote a part of their portfolio to dividend-paying companies for the income that they can provide in retirement, in addition to the potential of the stocks to appreciate in value.
In addition, the income from dividends and the relatively lower volatility of dividend stocks can be a hedge against poor security performance, loss of principal, and increasing inflation.