Imagine an investment that offers you a predictable, consistent income that rises over time. One that, while not guaranteed, is reliable and has been used by countless others to generate income during retirement.
What is the source of this idyllic income stream? Dividends. More specifically, dividends from publicly traded companies or mutual funds that own them.
If you ate cereal for breakfast, drank a soft drink at lunch, and drove to the store to pick up a few things on your way home from work, odds you consumed several products that were made by companies that have been distributing cash to shareholders via dividends for many years.
Dividends might not be the sexiest investment you will ever own, but they should play a vital role in your retirement income plan.
Below are 3 big reasons why dividends should be part of your retirement income plan:
Dividends are predictable. When a company pays a dividend, it returns capital to investors in the form of a specific dollar amount based on how many shares of that company they own. Usually, the dividend is expressed as $1 a share or some other specific amount that is to be paid to shareholders who own that stock (or mutual fund) on a specific date.
For example, XYZ, Inc. may announce a cash dividend of $1 per share to be paid quarterly to shareholders of record. Owners of XYZ, Inc. shares could reasonably predict that they will receive 4 quarterly payments of 25 cents for each share of stock they own.
Unlike future stock prices, which are inherently unknowable from one quarter or one year to the next, dividend payments are quite predictable. As such, they can provide retirees with a predictable source of retirement income for at least a portion of their retirement income plan.
Dividend income is consistent income. When you were working, I am sure you appreciated a steady paycheck. Dividend income can help keep your retirement paycheck steady as well.
No dividend is ever guaranteed, of course. A company’s board of directors has the right to lower or even discontinue dividends whenever they like. In fact, this happens all the time.
However, most companies are very reluctant to reduce or discontinue dividend payments to their shareholders. More often, dividends are paid out consistently over very long periods of time, often decades. In fact, some companies have even paid dividends for more than a century!
Dividend income rises over time. Who doesn’t like to get a raise every now and then? Just because you are retired doesn’t mean that your income needs to stay fixed forever. In fact, just to keep up with inflation your income must rise over time.
As noted above, dividends can be fickle. A board of directors can reduce or even discontinue a company’s dividend payment. However, not only do many companies consistently pay dividends year in and year out, but often these dividend payments rise over time.
How much a dividend can rise varies from company to company. The key thing is to find companies that have consistently increased their dividend by more than the rate of inflation over time. An annual dividend increase of even just 4% or 5% would be more than double the rate of inflation.
Imagine having more income 10 years after you retire than you had the year you retired. With dividends, that’s possible. If your dividend income rises 7% or more each year, 10 years from now your dividend paycheck will be double what it is today. An 11% annual increase triples your dividend income over the same period.
Bonus benefit: As if predictable, consistent, rising income weren’t enough, dividends often have one more benefit that makes them such a valuable source of retirement income: dividends are taxed at lower rates!
Any income, including dividends, that comes out of an IRA or workplace retirement plan is taxed as ordinary income and at the usual tax brackets. However, if you own dividend paying stocks (or mutual funds) in a taxable account, those dividends are usually taxed at 15% (12% starting in the 2018 tax year) or even 0%!
How much tax you pay on your dividend income depends on your overall taxable income. For a more complete description of how dividends are taxed, click here.
No magic bullet. Dividend income isn’t perfect. Stock values fluctuate. Companies can reduce or eliminate their dividend payment. Taxation of future dividend payments is subject to the will of Congress.
Social security, pensions, and other forms of income should be part of a diversified income strategy in retirement. If you like predictable, consistent, rising income, consider adding dividend income to your long-term retirement income plan as well.