The rising and falling of stock prices may get a lot of attention, but dividends can play a huge role in an investor's total returns. With Dividend Kings -- which are companies that have managed to increase their yearly dividend for at least 50 consecutive years -- and dividend-focused index funds, dividends can be a reliable source of income. It's a way for companies to reward shareholders for being patient.
Part of being patient should be delaying receiving your dividend payouts as cash until retirement. Here's why.
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Add to the compounding effects
Most people don't have hundreds of thousands of dollars they can use to make a lump sum investment, but with dollar-cost averaging, time, and patience, you can get a good amount over time. As you're building up your dividend portfolio, one of the best things you can do is enroll in a dividend reinvestment plan (DRIP). DRIPs take the dividends you receive and automatically use them to buy more shares of the company or fund that paid it out, adding to the total return and increasing the compounding effect. From 1960 to 2021, reinvested dividends were responsible for 84% of the S&P 500's total returns.
Let's use the Vanguard High Dividend Yield ETF, which has returned close to 8% annually since its inception in November 2006, as an example. Accounting for the fund's 0.06% expense ratio, here's how much you would roughly have accumulated in 25 years if its dividend yield stayed at 3% and you reinvested it:
| Monthly Contributions | Annual Return (Including Fees) | Account Value After 25 Years |
|---|---|---|
| $500 | 10.94% | $680,000 |
| $1,000 | 10.94% | $1.36 million |
| $1,500 | 10.94% | $2.04 million |
Data source: author calculations.
Even if you take away dividend yields, with a modest 8% annual return, you could accumulate over $438,000 by investing $500 monthly for 25 years -- while only personally contributing $150,000. However, the real magic kicks in when you reinvest your dividends.
Use dividends as additional income in retirement
A great strategy is to let your dividends compound until you get to retire and then begin taking the dividend payouts as cash. At the above account total, here's what a 3% yearly dividend payout would look like:
| Account Total | Annual Dividend Payout |
|---|---|
| $680,000 | $20,400 |
| $1.36 million | $40,800 |
| $2.04 million | $61,200 |
Data source: author calculations.
At those yearly payouts, you could have an additional $1,700, $3,400, and $5,100 in monthly income. If you follow the 80% rule -- which states you should aim to have 80% of your annual income in retirement -- $40,000 to $60,000 in annual dividends would be enough for someone making $50,000 to $75,000 annually.
Even if you don't manage to get to the point where you can live off your dividends alone, they can be a great supplement to other forms of retirement income, like a 401(k), IRAs, and Social Security. Getting dividend payouts along the way while you're investing is good, but it's often better to be patient and delay your payouts until retirement. You'll likely be glad you did.
