Dividends are a great way for investors to be rewarded for patience. What many stocks might lack in price growth potential, they make up for with quarterly dividend payouts.
Dividend Aristocrats, which are companies that have managed to increase their yearly dividend for at least 25 consecutive years, separate themselves from other companies because they've shown they can keep their balance sheets healthy through the good, the bad, and the ugly.
Investors should consider Dividend Aristocrats in any of their accounts, but they can be especially useful in a Roth IRA. Here are three reasons.
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1. They lessen what you owe to Uncle Sam
Usually, when you sell your stocks and make a profit, you'll owe taxes on the capital gains. Stocks held less than a year are taxed at your regular income tax rate; stocks held a year or longer are taxed at your capital gains rate -- which is cheaper, but a tax nonetheless. The main benefit of a Roth IRA is that you can take tax-free withdrawals beginning at age 59 1/2, potentially saving you tens of thousands of dollars in taxes.
For the 2022 tax year, the most you can contribute to an IRA, both Roth and traditional combined, is $6,000 ($7,000 if you're 50 or older). Let's imagine there are two people, both of whom invest $6,000 annually, with 10% average returns over 25 years. At the end of those 25 years, both investments would be worth just over $590,000, although both only personally invested $150,000 over that span.
If one person made those investments in a regular brokerage account or traditional IRA, they'd owe taxes on the $440,000 in capital gains when they sold the stock(s). Assuming that person makes over $40,400, they'll pay 15% at minimum in capital gains, bringing their bill to at least $66,000. If the other person made those same investments in a Roth IRA, the full $590,000 would be theirs (assuming they're 59 1/2 or over).
2. They can provide supplemental income
Ideally, you would use your broker's dividend reinvestment program and reinvest your dividends until you retire, and then begin receiving them as cash payouts for supplemental income. Dividends, when reinvested back into the stocks that paid them, create a compounding effect.
If we use the same example of someone investing $6,000 annually with 10% average annual returns, assuming a constant 2.5% dividend yield, the account value would be over $864,000 in 25 years -- around a $274,000 difference compared to an account without the dividend. If you were to begin taking the dividends as cash at that point, that's $21,600 in annual income. That's not enough to survive on alone, but when used in addition to other sources like a 401(k) and Social Security, it's a great boost.
3. Reliability is good in retirement
Increasing your yearly dividend for at least 25 consecutive years is no small feat. Over the past 25 years, the U.S. has experienced the dot-com bubble (late 1990s), the financial crisis/Great Recession (2008), and the pandemic (2020). All three of those events created abnormal economic conditions, yet Dividend Aristocrats managed to survive and continue rewarding their investors along the way.
As you're prepping for retirement, it's always good to have reliability. There will always be uncertainty in the stock market, but you can reduce this degree of uncertainty to an extent by going with Dividend Aristocrats that have stood the test of time. You can be all but certain of the dividend being paid every quarter like clockwork.
