Unveiling Potential Drawbacks of Dividend Investing, as Revealed by a Financial Consultant
Building Wealth, a free, twice-weekly newsletter, offers expert tips to help individuals grow and preserve their wealth. In this article, we delve into the world of dividend investing, a strategy that involves purchasing stocks that regularly pay a portion of their earnings to shareholders.
However, it's essential to understand that high-dividend investing is not a magic formula for generating income, especially in retirement. A total return strategy, focusing on growing a portfolio and taking income when it's most tax-efficient, can be a more effective alternative.
In a taxable account, qualified dividends are taxed at capital gains rates (0%, 15%, or 20%). Non-qualified dividends, on the other hand, are taxed at ordinary income tax rates, which can reach up to 37%. This means that high-income retirees or those with other income sources may face significant tax bills from dividends.
The Kiplinger Building Wealth Program, developed by the Kiplinger organisation, emphasises growth, flexibility, and thoughtful planning. Tools like Qualified Charitable Distributions (QCDs) and Donor-Advised Funds (DAFs) can help shape a retirement story in a way that puts individuals in control of their future, taxes, and giving.
QCDs allow IRA owners age 70 1/2 and older to give up to $100,000 per year directly to a qualified charity, without it counting as taxable income. This can help avoid taxes on up to $100,000 of IRA distributions, reduce adjusted gross income, lower taxes on Social Security and Medicare premiums, and shrink future required minimum distributions (RMDs).
DAFs, on the other hand, allow individuals to make a financial contribution and give the money to charities later, on their own timeline. They can help make multiple donations in a high-income year for a bigger tax deduction, contribute appreciated assets (such as stock) and avoid capital gains, and continue giving year after year from one place, while growing the funds tax-free.
It's important to note that Dividend-heavy strategies can limit diversification, as they focus on a specific type of investment and may not provide exposure to other asset classes. Dividend stocks are not a safe, bond-like replacement, as they carry equity market risk and can drop significantly during market crashes.
Companies that pay high dividends are often mature, with fewer reinvestment opportunities, which can lead to slower growth, less innovation, and potentially lower returns. Furthermore, companies can cut dividends at any time, as examples like GM in 2009, BP after the Deepwater Horizon incident, or Disney in 2020, demonstrate.
In conclusion, while dividend investing can be a part of a well-rounded investment strategy, it's crucial to consider the potential risks and tax implications. QCDs, DAFs, capital gains timing, and Roth conversions during low-income years can help create a flexible, tax-savvy, and retirement-optimized financial plan. Remember, dividends are not free money, but rather a reshuffling of value where the share price drops by the amount of the dividend paid.
This article was written by a contributing adviser and presents their views, not those of the Kiplinger editorial staff. In 2022, more than 60% of U.S.-listed companies didn't pay dividends, highlighting the importance of diversification in any investment strategy.
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