Dividends are payouts to shareholders from a company's profits. Growth stocks and younger companies typically don't pay out dividends because they need to reinvest profits to continue growing at a high rate. However, once a company reaches a certain size, its room for high growth typically decreases, so companies will pay out dividends to incentivize investors to continue investing in them.
Dividend stocks aren't as flashy or get the attention that growth stocks tend to, but there's no denying they're just as, if not more, lucrative for investors.
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It pays to hold onto dividend stocks
A large part of the appeal of dividends is that they're close to guaranteed income, and investors don't have to worry as much about a stock's price movements because they'll be getting paid their dividend regardless. Is the stock price up 10%? Expect your dividend. Is the stock price down 10%? Expect your dividend. The stock price flat? Expect your dividend.
There are situations where a company may cancel its dividend -- like Delta (DAL 0.74%) during the start of the COVID-19 pandemic -- but if you're investing in dividend aristocrats, you don't have to worry too much about that problem. Dividend Aristocrats are S&P 500 companies that have managed to increase their yearly dividend payout for at least 25 consecutive years. The title of Dividend Aristocrat gives investors confidence that a company has the financial resources to weather broader economic problems and still produce good returns.
Dividends add to the effects of compound earnings
Looking to build wealth in the stock market? Learn to appreciate the power of compound earnings. Compound earnings occur when the money you earn on your investments begins to earn money on itself. Compound earnings by themselves are powerful, but the effects increase when you reinvest your dividends into the stock that paid them. And it doesn't take much effort; you can enroll in your broker's dividend reinvestment program to have it automatically done for you.
Let's take the Vanguard High Dividend Yield ETF (VYM 0.64%)as an example. Since its inception in 2006, the ETF has returned just over 8% annually. Imagine if you invested $500 monthly into the fund, receiving those same returns for 20 years. At the end of that span, your investment would be worth over $274,500. If we assume its current 3% dividend yield stayed constant during that span and you reinvested the dividends, your investment would increase to over $385,200 after 20 years.
It's usually better to delay your dividend payouts in cash until retirement so you can give it time to compound and increase your stake in the stock that's paying it. A 3% dividend yield may not be much today ($300 per $10,000 in value), but once you've accumulated a sizable stake throughout a career, it can be great supplemental income in retirement.
Tax-free dividends
If you're eligible to contribute to a Roth IRA, you should definitely consider taking advantage of it. Unlike a 401(k) or traditional IRA, a Roth IRA account allows you to take tax-free withdrawals in retirement. Most people fall into the 15% capital gains tax rate bracket, so that means for every $100,000 you have in capital gains, you'll owe $15,000 in taxes. Depending on how much you're able to save up in a Roth IRA, tax-free withdrawals could easily save you well into the five-figure range.
Using our Vanguard High Dividend Yield ETF example, if you had $385,000 in the fund with a constant 3% dividend yield, it would pay out $11,550 in annual dividends. If you held it in a Roth IRA, every penny of the dividend payouts (as well any other amount you withdraw) would be yours. If you held it in a regular brokerage account, you'd pay taxes on the dividend payouts each year.
Any money not paid in taxes is money you can use to enjoy retirement.
