5 Strong Stocks for Your IRA

Tax-deferred accounts such as traditional and Roth IRAs are ideal places for income-generating investments such as dividend-paying stocks and bonds. Why? Rather than pay taxes annually on dividends and interest received, IRAs allow your nest egg to grow tax-free, entirely avoiding those annual charges that can put a damper on your retirement funds' returns.

In this low-interest rate environment, however, the income opportunities in the bond market are slim -- the Vanguard Total Bond Market Index (VBMFX), for instance, yields just 3.3%. And while there's a clear benefit to holding high-quality bonds as part of your retirement portfolio, you also want to grow your portfolio more quickly than inflation between now and the time you begin drawing from your IRA.

Dividend-paying stocks can help you achieve the twin goals of income and inflation protection.

How to find the right ones
Following a year in which once-reliable blue chips like JPMorgan Chase (NYSE: JPM  ) and US Bancorp (NYSE: USB  ) slashed billions of dollars in dividend payouts, you'd be wise to approach dividends with a little more skepticism than before. It's true that future dividend payouts are by no means guaranteed, but there's no denying the power of dividends reinvested over decades in an IRA.

Consider the difference in the after-tax returns on a $1,000 investment in Johnson & Johnson from November 1989 through the present:

Metric

Return in IRA-Dividends Reinvested

Return in Taxable Account-Dividends Reinvested*

After-Tax % Return

1,193%

1,128%

*Assumes top dividend tax rate from Nov. 23, 1989-Nov. 23, 2009.

On a percentage basis, taxation doesn't appear to make much of a difference. But in dollar terms, it yields a $654 difference on the income return for every $1,000 invested.

Another thing to keep in mind when reading this table is that Johnson & Johnson yielded just 2% at the time of purchase, which was well below the S&P average of 3.3% in 1989. A higher-yielding stock would have created an even wider difference in after-tax return.

Finally, in 2003 the qualified dividend tax was capped at 15% under the Bush tax cuts; previously, the usually higher marginal income tax rate applied. With those cuts set to expire next year, the dividend tax will likely be higher, making an IRA an even better place to store your dividend payers.

OK, how about some names?
By looking for stocks that meet the following criteria, we improve our odds of finding a strong company that can not only continue to make its current dividend payouts, but also increase them over time:

  1. An above-average dividend yield
  2. Sufficient free cash flow cover
  3. A history of dividend hikes
  4. A solid balance sheet
  5. Undervalued versus the market

Here are five stock ideas that meet these criteria. Each is a great place to start your research:

Company

Dividend Yield

Free Cash Flow Payout Ratio

Procter & Gamble (NYSE: PG  )

2.85%

39.6%

Intel (Nasdaq: INTC  )

3.27%

60.3%

Honeywell (NYSE: HON  )

3.18%

27.7%

PepsiCo (NYSE: PEP  )

2.90%

59.1%

Exelon (NYSE: EXC  )

4.49%

37.1%

*Source: Capital IQ, as of Nov. 23, 2009.

Encouragingly, many more companies showed up on this screen, based both in the U.S. and abroad. Together, they were more than enough to build a diversified portfolio of solid dividend payers in an IRA. Equal amounts invested in the five stocks above, for instance, would produce an average yield of 3.3% (just below the Vanguard Total Bond Market Index). Moreover, since each has a strong track record of raising dividends, the increasing payouts will help you battle inflation.

Selectivity is key
Despite the lumps dividend investors have taken over the past year, they're still an essential part of any retirement portfolio, though some extra prodding is necessary. With yields at some very healthy companies the highest they've been in decades, now's the time to go shopping for quality dividend stocks for your IRA.

I've started you off with five strong stocks to research, but if you're looking for even more dividend stock ideas, our Motley Fool Income Investor service can help. Advisor James Early and the Income Investor team recommend both stocks with high yields and those focused more on dividend growth. At present, their picks yield 4.2% on average, and have outperformed the S&P by seven percentage points on average since the service's inception in 2003.

A 30-day trial of Income Investor is free. If you'd like to learn more about the service, just click here.

This article was originally published on Sept. 25, 2009. It has been updated.

Fool analyst Todd Wenning made himself a dang quesadilla for lunch today and recommends you do the same. He owns shares of Procter & Gamble and Johnson & Johnson -- both are Motley Fool Income Investor selections. PepsiCo is also an Income Investor pick. Intel is an Inside Value choice. Motley Fool Options has recommended calls on Intel. The Fool owns shares of Procter & Gamble and has a disclosure policy.


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