Peanut butter and jelly are good individually, and great when paired together. The same dynamic exists between retirement accounts and dividend stocks. Read on for three reasons why holding dividend stocks (or funds of dividend stocks) in your 401(k) or IRA could be the retirement strategy you need.
1. Tax-deferred earnings
401(k)s, traditional IRAs, and Roth IRAs share a valuable tax feature -- tax-deferred earnings. This means you don't pay taxes annually on dividend income in these accounts. You also won't pay annual taxes on realized gains or earned interest.
If you hold dividend stocks in a taxable account, you probably owe 15% or 20% of your dividend income to the IRS each year. But in your retirement account, you can leave those funds invested. And the more money you have invested, the faster your balance can grow.
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2. Passive retirement income machine
Dividend stocks and dividend funds produce passive income, which is very useful in retirement. The more cash you are generating as a retiree, the less reliant you are on selling shares to fund your retirement distributions. Selling shares reduces your future earnings potential and shortens the lifespan of your nest egg.
Imagine if you held enough dividend-paying stocks to fund 100% of your retirement income needs. You could live off those dividends indefinitely while maintaining your wealth. You'd likely have the flexibility to splurge occasionally or leave a sizable inheritance for loved ones.
To grow your passive retirement income machine, reinvest your dividends while you are still working and contributing to your retirement account. Each reinvestment increases your share count and income potential.
Once you retire and start taking distributions, you can elect to receive your dividends as cash income. You'd then use that cash as your first source for funding retirement distributions.
3. Built-in inflation protection
Inflation is a real challenge for retirees. In 10 years, a moderate 2% inflation rate increases the cost of $100 worth of stuff to $121.90. That puts a slow and steady squeeze on retirees' budgets over time.
Dividends can provide inflation protection. According to iShares, the growth in dividends paid by U.S. companies has outpaced inflation over the past 150 years. Specifically, the annual dividend growth rate was 3.7%, while inflation grew 2% annually between 1871 and 2021.
There is also a category of dividend stocks known for increasing dividends consistently from year to year. These are called Dividend Aristocrats. To earn the Aristocrat title, a company must have raised its dividend consistently for at least the past 25 years.
That history doesn't guarantee the dividend increases will continue forever, of course. But it does show a company's deep commitment to those shareholder payments. Usually, corporate leaders are reluctant to lose the Dividend Aristocrat title once it's been earned.
A dynamic duo for retirement
Retirement accounts and dividend stocks are a dynamic duo for retirement planning. Your dividend-paying assets generate rising income over time. And the retirement account protects you from wealth-depleting taxes as you build your nest egg. That's a powerful one-two punch to help you reach your retirement goals.
