If you don't have a pension, and don't expect Social Security to meet your retirement needs, income investing can become a powerful plan B. But you're not careful, you could end up blindsided by some of this strategy's notable drawbacks.
The silent wealth killer, inflation almost constantly eats away at the value of your holdings. A 3% average inflation rate can reduce an annual investment gain of 10% to just 7%. (That's why we refer to returns that incorporate inflation's effects as "real" returns.)
These days, if you're investing for income via savings accounts, CDs, or money market funds, you're probably losing ground to inflation. Earning 2.75% on a five-year CD when inflation averages 3% means you're not building any real wealth. And while inflation's been unusually low in recent years, any future economic recovery could give it a significant boost.
Depending on which investments you turn to for income, you'll pay different amounts in taxes. Bond income gets taxed at your ordinary income rate -- 25% to 28% for most people, although it can go higher. Dividends from stocks have recently enjoyed a far lower taxation rate of 15%.
However, both those figures could rise significantly, as our cash-strapped government turns to taxes to stem its rising tide of expenses. Taxes on dividends and stock gains could increase to 20% or more, and folks in the highest tax brackets will soon pay a new 3.8% payroll tax on their investments.
In most cases, taxes are unavoidable -- but qualifying investors might have one narrow escape hatch. You won't pay a dime in taxes on investments in a Roth IRA, even if they pay dividends. Depending on your particular needs, and your tax bracket, dividend-paying stocks in a Roth might be a better investment than highly taxed bonds in a regular account.
Many investors turn to mutual funds for convenient one-stop exposure to bonds or dividend stocks. But the allocations those funds choose could leave your money especially vulnerable to big swings in a single sector of the market.
A recent Wall Street Journal article noted that 46% of the iShares Dow Jones Select Dividend Index ETF
These cautions shouldn't keep you from investing in strong dividend-paying stocks. The best of them will pay you steadily, even as they rise in value on their own. For instance, the iShares ETF includes McDonald's
Don't let the threat of taxes and inflation drive you away from dividends. For all their potential pitfalls, income stocks remain some of the most attractive investments on the market.
Longtime Fool contributor Selena Maranjian owns shares of McDonald's. Nokia is a Motley Fool Inside Value choice. Apple is a Motley Fool Stock Advisor selection. Try any of our investing newsletter services free for 30 days. The Motley Fool is Fools writing for Fools.