But what about total returns?
As I mentioned above, I focus on companies that I believe will increase earnings per share over time. This is the driver behind dividend growth over time. A company with rising earnings per share would likely increase in price over time. As a result, I do hope that the companies I buy will be more valuable over time, and would generate total returns. However, I focus on dividends because they are a more reliable portion of total return than capital gains for living off your nest egg.
What about taxes?
Qualified dividends derived from U.S. corporations are taxed at a maximum tax rate of 23.80% to U.S. residents. This is much lower than tax rates on interest income, which is taxed much higher at the ordinary income tax rates (except muni-bonds). Unfortunately, if your income is less than $400,000 for single or $450,000 for joint returns, you would pay anywhere from 0% to 15%.
Taxation varies for REITs and MLPs, and is unique to the entity paying them and the personal situation of the individual receiving distributions from these entities. Not investing in dividend stocks and equities in general because they could result in tax liabilities is not a smart strategy to follow. It is possible for U.S. investors to defer/avoid paying taxes on investment income if it is placed in tax-advantaged accounts such as 401(k), IRA, ROTH IRA, SEP IRA etc. If you are a U.S. resident investing in foreign corporations, you might end up paying withholding taxes on dividends received, even if you held them in a tax-advantaged account however.
But is a 2% yield sufficient to protect you against inflation?
I focus on companies which have yields that look low today, but which I believe would increase dividends above the rate of inflation. If this dividend growth is fueled by earnings growth, chances are that stock price will increase as well.
For example, let’s examine a situation where you bought a dividend growth stock that trades at $100 per share, earns $5 per share and pays a $2 annual dividend. If this company is able to grow earnings and distributions by 7% per year over the next decade, and inflation grows at 3% per year, you will be ahead of inflation. That means that in year two, the company would earn $5.35 per share, pay $2.14 per share and likely trade around $107 per share.
In order to maintain purchasing power in year two as year one, the stock would have had to trade at $103 per share and would have had to pay $2.06 per share. If you add in that excess over inflation, it can lead to more wealth over time. Since 1920, dividends on the Dow Jones Industrials have increased by 5% per year, which was 2% higher than inflation. As a result, I find dividend growth stocks to be the perfect source of inflation proof source of income.
But I would need $500,000/$1,000,000 invested in dividend paying stocks to make a meaningful amount of dividends to live off?
In order to live off your nest egg, you need to build a nest egg first. I focus on building income, rather than a set amount to invest in. However, if you are just getting started and need $40,000 in annual income, you would likely need to invest about $1 million in dividend paying stocks. However, if you asked a traditional portfolio planner/financial adviser, they would have advised you to have $1 million in your portfolio and follow the traditional 4% rule. As a result, the requirement to have a nest egg to live off of with dividend stocks is no different than what you would need in a traditional index funds/bond fund allocations. The goal is to start as early as possible, in order to get time and compounding on your side. Dividend investing is not a get rich quick scheme.