Your retirement is likely to be the biggest expense your investments will ever need to cover. To enable the money you've accumulated to handle that incredible effort, you'll want to put every reasonable tool you can to work on your behalf.
Dividend-paying stocks are an often overlooked but incredibly powerful investment vehicle that can help you build and manage your wealth more effectively. While each dividend payment may seem small on its own, over time, they can compound together to deliver incredibly strong rewards. These five reasons to invest in dividend-paying stocks for your retirement should help build your understanding of how those cash payments can add value for your plan.
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No. 1: Dividends compound your wealth that much faster
Say you bought $100 worth of SPDR S&P 500 ETF, a S&P 500 index tracking ETF, on the day it launched in January 1993 and just held on to it. As of August 27, that $100 would be worth either $1,024.75, $1,200.97, or $1,745.17 depending entirely on what you did with the dividends you received on that investment.
If you spent those dividends, you'd have $1,024.75 from the price accumulation alone. If you let those dividends pile up as cash, you'd have $1,200.97. If, instead, you reinvested your dividends in the same SPDR S&P 500 ETF, you'd be sitting on an investment worth $1,745.17. In other words, your nest egg would be larger by more than seven times your initial investment just because you chose to reinvest your dividends instead of spending them.
That's an incredibly powerful lesson in just how important those seemingly small dividends can be when it comes to building and compounding your wealth over time. Now, just imagine what would happen if instead of just a single investment, you made regular investments and reinvested your dividends along the way.
No. 2: Dividends can tell you what management really thinks
The beauty of most dividends is that they get paid in cold, hard cash. For a company to offer its shareholders a dividend payment, the company needs to either earn that cash, draw it off its balance sheet, or borrow money to hand it out to its shareholders.
Of those three, only one method -- earning it -- can really be sustained over time. As a result, carefully watching what companies do with their dividends and comparing it to what they say about their business prospects can tell you a lot about management and what it really thinks.
If a company talks about great growth but its dividend either doesn't move or barely budges, then it's a pretty good sign that either that growth will be very expensive to achieve or may not really materialize. On the flip side, if a company talks down its growth but dramatically increases its dividend, then it's a sign it expects to be a cash cow -- generating more money than it can put to good use internally.
Either way, watching its dividend policy can be a great way to get insights on how the company's management thinks.
No. 3: Dividends can be great early warning signs of pending troubles
It's fairly easy to track dividend growth rates over time as well as to track key measures of dividend health like a payout ratio or percentage of operating cash flows used to fund the dividend. A drastic slowdown or stoppage of dividend increases or a deterioration of a key payment coverage ratio can provide an early clue to pending longer-term troubles with the business.
After all, dividends require cash, and if a company runs into trouble, it may need to redeploy that cash to shore up its operations. Deteriorating coverage measures can be a sign of tough choices ahead, and a slowing dividend growth rate can be a sign that the company's prospects are weakening. Either way, they provide a great signal to investors to take a deeper dive into what's happening in the company to make a rational decision on whether to buy more, hold, or sell.
No. 4: Dividends keep you in control of more of your money
When a dividend gets paid in cash, you get that cash. You can use it to rebuild your cash buffer or bond ladder, supplement the money you use to cover your expenses, or reinvest it in pursuit of future growth and dividend opportunities. The point is -- cash paid out as dividends is just as useful as any other form of cash you have available to you.
Even better, dividends tend to get paid out based on the health of the underlying business, not the whims of the market. That makes it more likely that they will continue to get paid even if the market happens to be throwing a fit at the time.
Key to remember, though, is that dividends are never guaranteed payments. As a result, it makes sense to arrange your finances such that you aren't depending on them to cover your core costs of living.
No. 5: Many dividends come with tax benefits
If you're investing outside of a retirement account, the dividends you get paid might come with a surprisingly small tax bill attached. For most Americans, a qualified dividend may come in tax free or get taxed at only a 15% rate. Even for high earners, federal dividend tax rates top out at around 24% after the Net Investment Income Tax is added.
Non-qualified dividends are a different story, as they're generally taxed at the investor's ordinary income tax rates. Even there, though, there may be tax benefits. Many companies that pay out non-qualified dividends pay their shareholders a mix of ordinary dividend, capital gain, and return of capital in their distributions. The capital gain and return of capital portions of a distribution can have tax advantages over ordinary income, which helps make those companies more attractive to shareholders.
Either way, dividend income is never subject to Social Security tax, and since you don't need to work to earn your dividends, you don't need to cover the costs of working, either. For instance, there's no commute cost, no wedding or birthday gifts for coworkers, and no mandatory happy hours. In addition, if your job is in a higher tax location than your home, you don't need to pay the higher costs of the taxes associated with that work location on your dividend income.
Make your money work for you
Perhaps best of all, dividend stocks provide an incredibly clear example of how when you invest, your money can work for you. A carefully shepherded growing steam of dividends, increasing from company actions, reinvestment, and new contributions, can hand you tangible cash rewards for the risks you take by investing. Over time, that can lead to a nest egg that comfortably covers your costs and enables a financially successful retirement.
The key thing to remember about investing, though, is that most of the benefits come over time. The sooner you take your first steps down this path, the more time you'll be able to put your strategy to work for you. So get started now, and boost your chances that dividend stocks can help you to -- and through -- the retirement you'd like to live.
