Dividend stocks are an important part of most retirement portfolios. These stocks have a unique set of features that are important for investors in their golden years. Don't ignore these three benefits when you're setting up your retirement plan.
Cash flow is the name of the game in retirement planning. You'll stop working one day, but you won't stop spending money. That void needs to be filled with income from new sources.
Social Security is the most important source of income for most retirees. The average monthly benefit will be $1,657 in 2022, so many households will require more to meet their needs. One-third of people who retire today have pensions, and those generally add $10,000 to $20,000 to annual cash flow. You'll usually have to rely on your own investments for any additional income.
Investment income usually comes from interest and dividends. Bonds are useful financial tools that pay interest at regular intervals, and they're also popular among retirees because bond prices don't fluctuate as much as stocks.
Dividend stocks also generate regular income streams, but they still experience market volatility. Some companies decide to take their profits and distribute those to shareholders. These are usually mature, stable companies with limited growth potential. They don't have to invest aggressively in product development, new hires, or corporate infrastructure, freeing up more cash flow to the business. Instead of doing nothing with that cash, they cut checks periodically to their investors.
Retirees can own dividend stocks in their retirement accounts or in a brokerage account. They'll kick off income that you can use to meet your basic needs and lifestyle goals. Right now, reliable dividend yields are around 2% to 3%.
2. Tax treatment
Taxes are an important part of investment planning, but they're overlooked too often. That's especially true for retirees. For many investors, dividends receive preferential tax treatment.
If you happen to have a Roth IRA, you can enjoy tax-free dividend income. Investment returns in a Roth are distributed tax-free prior to age 59 and a half, including dividends. You'll have to set up a Roth using earned income prior to full retirement, and you probably won't be able to make contributions after you stop working.
Dividends are also tax-deferred within traditional IRAs and 401(k) accounts. However, when you take distributions from those accounts, they will eventually be taxed as ordinary income. This gives you the ability to decide when the tax is incurred, which is a strategic advantage. However, don't expect to bypass the IRS like you can with a Roth.
Dividends can also get special treatment in normal investment accounts. Dividends are considered "qualified" if they meet certain criteria, but it's really common for retirement accounts to produce qualified dividends. This basically means that these distributions will be taxed at a capital gains rate rather than income tax rates, which can be advantageous for many investors.
3. Stable growth
You can't just ignore investment growth once you've retired -- it's still important. Volatility management is important if you need to take distributions from your retirement account, but you also need to prepare for multiple decades of potential cash needs. That's only possible with some asset growth.
Dividend stocks are a great source of growth, but they also offer more stability than the market in general. The ProShares S&P 500 Aristocrats ETF (NOBL -0.39%) holds Dividend Aristocrats. On top of the dividends it's paid to shareholders, the ETF's price has increased nearly 80% over the past five years. Investors get periodic cash flow while their pool of assets also rises.
Even though the ETF only holds around 65 stocks, it's less volatile than the market in general. Its beta is only 0.70 which indicates that it doesn't rise or fall as drastically as the S&P 500. Dividend stocks are rarely growth stocks, because their sales and profits tend to grow slowly and steadily over the long term. Their cash flows are more predictable, so these stocks usually have more modest valuations that are based on expected dividends. That means that they don't have as much room to tumble during bear markets.
Dividend stocks provide better long-term growth potential than bonds. At the same time, they tend to be lower risk and lower reward than growth stocks. Those are both ideal features for investment portfolios in retirement.