Stocks that pay dividends can be enormously appealing to retirees. But what to do with those dividends can be confusing. Should you participate in a Dividend Reinvestment Program (DRIP)? Or should you just cash the check?
Before answering that question, let’s learn a little more about dividends.
Different companies offer shareholders different kinds of potential financial benefits or returns.
Dividends are one type of benefit. They are cash payments or shares of stock or other property that are paid to shareholders at the discretion of the board of directors. They are usually based on profits.
Most start ups or high growth companies do not usually offer dividends. Their profits are typically getting reinvested into the company and the key benefit of a high growth company is usually the increase in the stock price.
Dividends are typically offered by large well established companies where profits are slightly more predictable and growth is less likely to be explosive. According to Investopedia, companies in the following sectors are more likely to pay dividends: basic materials, oil and gas, banks and financial services, healthcare and utilities.
The simple answer is no. Both dividend producing companies and those that don’t produce dividends have the potential to be smart investments.
In fact, experts argue that if two companies are identical in profit and growth, but one offers dividends and the other offers stock growth, your return on investment in the long run would be equal from each company. The dividends offset growth.
Some mutual funds and ETFs pay dividends. In fact, some are even designed with the goal of generating significant dividend income.
DRIP stands for dividend reinvestment plan. This is a program offered by many companies (and funds) to give the shareholder the option of using the dividend to buy more shares.
According to a recent article from AAII, there are several significant advantages to a DRIP program:
No Commissions: DRIPs offer shareholders a way to accumulate more shares without having to pay a commission.
Discounts: Sometimes the DRIPs are offered at a discount off the current share price.
Bargain Prices: The lack of commission and the discounts make DRIPs a unique way to get stocks at a genuine bargain.
Compounding: DRIPs enable you to compound your returns and over time this can result in an increase in the total return potential of the investment.
Set it and Forget it: DRIPs offer a good set it and forget it approach to investing. You set up the program and then you can be on autopilot and not need to worry about what to buy and when.
Dollar Cost Averaging: Dollar-cost averaging is an investment technique that aims to reduce the volatility of price fluctuations. By buying additional shares of stocks at regular time intervals (which is what you do when participating in a DRIP program), you might buy some shares at a high price and some shares at a low price. Like with most investment strategies, there are advantages and disadvantages to consider.
Many retirees forgo DRIP programs and instead draw their dividends and use them as a valuable source of retirement income. Dividends are particularly interesting as income because — in many cases — the dividends increase over time and may help your income keep pace with inflation.
Dividend producing investments can be particularly awesome if you have built up a sizable nest egg. For example, let’s say that you have saved $1 million and invest that money in dividend producing stocks. If you could earn an average of 4% in dividends, this would be retirement income of $40,000 a year.
And, you still have your ownership in the stock and you could sell the stock if you were to require additional funds.
Taxes: Taxes are the downside to almost everything. Depending on the type of account you have, the dividends are likely to be taxable.
However, qualified dividends are taxed as long-term capital gains, which typically carries a lower tax rate than ordinary income.
Unpredictable: While dividend producing companies are typically mature and stable, there is nothing to say that they will definitely stay that way. If company profits go down, then the dividends they pay will likely go down.
Take the recent example of the once luminous General Electric Co. Many analysts are predicting that GE may reduce their dividends.
Risk: Companies that pay dividends are usually less risky than other stocks. However, all stocks and funds are inherently risky. You need to be sure that you are adequately diversified and are not putting capital at risk that you may actually need.
If you intend to make dividends an integral part of your retirement income plan, you might want to know how to calculate and project them.
In the NewRetirement Planner, the best way to document dividend income is to enter the monthly payments as a passive income source. You should also be sure to enter the account principal as a savings account and not include expected dividends in the projected rate of the return.