If you're eligible to fund a Roth IRA, it's a must-have when saving for retirement. The money you put into it will grow until you're older, and you won't pay taxes on the gains when you take the cash out.
But you're only allowed to contribute a limited amount of money each year, so you need to be careful with your investment choices, because you might have a hard time making up for significant losses. That's why Roth IRA investors should consider a dividend growth strategy.
Here are three perks you need to know about.
1. Dividend stocks tend to be less risky
There's a lot to learn from the stock market swings over the past couple of years. Investors can be greedy, as they were in early 2021, and fearful, like many are today. Sometimes, stocks can trade to prices the fundamentals can't justify, and we've seen some stocks, especially unprofitable or more speculative companies, fall 80% to 90% over the past year.
I'm not saying that some of those investments won't work out long term, but is that a risk you want to take with arguably your most powerful investment vehicle? What if you were almost at retirement and your Roth IRA lost 50% or more of its value? Could you afford to wait for it to recover, especially without knowing that it will?
Or you sell out and are left trying to make up the losses. Remember, you can only invest a maximum of $6,000 per year until you're 50 and then just $7,000 per year. You don't want to put yourself in a position of having to make up for significant declines.
No stocks are risk-free, but dividend stocks tend to offer superior stability since companies must have profits to consistently pay out a dividend. If you focus on companies with dividends, especially those with track records of increasing the payout each year, you're less likely to suffer a catastrophic setback in your portfolio.
2. Reinvest your dividends tax-free
Dividend stocks have a little secret called dividend reinvestment plans, or DRIP for short. When a company pays you a dividend, you can automatically reinvest that cash into more company shares.
Of course, those new shares pay dividends too, so as each dividend payment comes, you steadily acquire more shares, increasing the payout you receive too. Reinvesting the dividends of companies that increase their payout each year can turbocharge your dividend income.
They can also make a huge difference in your returns. Real estate investment trust (REIT) Realty Income has been a solid investment, offering 10% annual returns to investors since 1995. However, reinvesting the dividends instead of pocketing them would raise your yearly returns to almost 15%. Over a long holding period, this can create vast amounts of wealth, and the best part is that doing this through a Roth IRA shields you from paying taxes on any gains.
3. Create a cash machine without having to sell anything
So what's the end goal of this? Imagine having a "golden goose" that did nothing but put cash in your pocket. You can build your Roth IRA as that golden goose for your finances. When the time comes, you can begin pocketing the dividends, using them to pay your living expenses while the stocks remain in your account and continue to grow.
Your Roth IRA could create enough dividend income to help out with your budget or be enough to live off of alone. A dividend stock strategy can be a great way to get the most out of a tax-advantaged account like a Roth IRA.
If you're unsure where to start looking, you can check out Dividend Aristocrats, stocks that have increased their dividend for at least 25 years straight, or Dividend Kings, those with 50 years o more of consecutive increases. Remember, a diversified portfolio of high-quality stocks can help you build wealth over time without taking unnecessary risks.