There are numerous theories that speak to the best method to save for retirement—a traditional asset allocation based on a time frame. This includes alternative asset classes to achieve diversification and dividends for income or to hedge against market risks. There are both advantages and disadvantages to using dividends during retirement.
- Investors own a portion of the company they have purchased shares of, making them entitled to a portion of the profits as well which are paid out in dividends.
- The dividends may be paid out at fixed rates for preferred shareholders or variable rates for common stock shareholders, and the payout is most commonly seen on a quarterly basis.
- Dividends can be used to hedge against volatility and inflation by providing a steady delivery of income.
- On the downside, companies can choose not to declare dividends, which can negate the benefit of diversifying a retirement portfolio with dividends.
- Dividends are taxed at the income tax rate, which is higher than the capital gains rate.
How Dividends Work
Before determining whether dividends are the best option for retirement savings, it is important to understand how dividends work. When an investor purchases a stock, they become a proportional owner of the company based on how many shares of stock are purchased. Because of this relationship, profit achieved by the company is shared with the shareholder in one of two ways:
- 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.
- The company’s stock price may increase over time, making the shares owned by the investor more valuable, also known as capital appreciation.
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.
Advantages and Disadvantages of Dividends
Most investors are concerned with poor investment performance, loss of principal and the constant threat of high inflation. Dividends can provide a hedge against these risks while saving for retirement.
Although equity investments are attractive to investors for the potential of higher returns, volatility within the market can be a cause for concern for investors saving for retirement. Focusing solely on capital appreciation through equity investments may not provide the consistency investors need in order to achieve retirement savings goals. Adding dividend-paying stocks to the asset allocation can help mitigate loss in equity positions.
Investors can use dividends to hedge against rising inflation for the long term. Although rates have been relatively low recently, inflation still has a corrosive effect on investment returns. Investors who hold positions in dividend-paying stocks may be better able to navigate higher inflation rates while saving for retirement.
Although there are reasons why investors may want to supplement capital appreciation in equity positions with seemingly steady dividend payments, there are caveats to consider. Dividends are not guaranteed; reliance on consistent payouts could skew savings projections in the wrong direction. Should companies decide to not declare dividends, investors could fall short of their savings goals.
Dividends are taxed at a qualified dividends tax rate which depends on the income bracket that the investor falls into, while the gains associated with the sale of appreciated stock are taxed at the lower capital gains rate. Paying higher taxes can have a detrimental effect when the time comes to take income in retirement.
Although dividends can present an opportunity for consistent growth and a hedge against inflation, investors saving for retirement need to be aware of the potential drawbacks to this investment strategy.