I love dividend stocks, but income investors face an inherent disadvantage against growth investors, one that costs them tens of thousands over decades of investing.
The disadvantage comes from the regular taxation of your dividend earnings. Each year, Uncle Sam takes his cut of your hard-earned dividend payments.
Since part of the returns of dividend stocks is lost each year, you lose the power of compounding seen in investments that aren’t taxed until sold. An investor in a dividend stock paying a 7% yield annually would see a $10,000 investment grow to $51,276 over 30 years, assuming reinvested dividends and a 20% rate on qualified dividends.
An investor putting $10,000 in a stock with a 7% price return but no dividend would see the investment grow to $60,898 over the same period (after adjusting for the one-time capital gains tax). The dividend investor has lost nearly $10,000 to the annual tax burden.
There’s one way to save this money and get the most out of your dividend investments — by holding high-yield stocks in a tax-advantaged retirement account like an IRA.
Sharing Your Dividend Income With Uncle Sam
Qualified dividend payments, paid when the investment is held for at least 61 days around the payment, are taxed at the same rate as capital gains (either 15% or 20% depending on your tax bracket).
That’s bad enough, but sell your dividend stock before the holding period qualification and those dividend payments will be taxed as income, meaning you could lose up to 39.6% to the tax man.
The immediate loss to taxes each year penalizes yield investors. The example above was on just $10,000 in investments. Focus your entire portfolio to dividend names and you could be out many times that amount.
The tax advantages of individual retirement accounts (IRAs) and other retirement accounts make them perfect for holding high-yield names.
In a traditional IRA, you get an immediate tax deduction on your income through the contribution. Your capital gains and dividends grow tax-free in the account until withdrawal in retirement, at which point you pay income taxes on the amount withdrawn each year.
If your income in retirement is lower than that when you were working, your tax rate could be significantly lower.
An oft-overlooked strategy is to open a Roth IRA as well as a traditional IRA.
Roth IRAs are funded with after-tax dollars so you don’t get that immediate tax break through a deduction but the money is tax-free when you withdraw it in retirement. That means all the dividends and capital gains you accumulate over the years are completely tax-free.
High-income earners are prohibited from opening a Roth IRA directly but can convert a part of their traditional IRA into a Roth by paying the income taxes on the conversion.
Finding High-Yield Dividend Stocks For Your Retirement Accounts
Any cash-yield investment, other than partnerships, should be considered for retirement accounts. The best investments for your tax-advantaged retirement IRAs are those that pay most of their return through a dividend.
Look for high-yield dividend stocks with a high payout ratio, defined as a high percentage of income paid out as dividends relative to the industry average.
Management, in offering such a high payout, has signaled its commitment to returning profits to shareholders rather than using them to drive price appreciation.
Asset managers and capital markets services are a great place to look for these perfect IRA investments. Companies providing investment banking and asset management typically return most of their income to investors each year because cash flows are relatively stable.
Switching costs to move money to a different asset manager are not particularly high but the benefits of switching are uncertain so customers tend to keep their money with an investment firm for a very long time.
Waddell & Reed Financial, Inc. (NYSE:WDR) paid out 106% of its income over the last year for a 10.5% dividend yield. The sale and maturity of some long-term investments has helped the $1.5 billion asset manager return more than it earned to investors for the last two years.
The firm’s in-house brokerage advisors help to create consistent inflows and the repeal of the proposed fiduciary rule could increase investment into more profitable products. WDR will also benefit as the millennial generation enters its prime earning and investment years over the next decade.
Greenhill & Co., Inc. (NYSE:GHL) paid out 110% of its income over the last year for a 7.2% dividend yield. Non-cash items like restricted stock benefits and depreciation allow the firm to support its dividend with a payout ratio above reported net income. Greenhill derives most of its revenue from M&A advisory, which should benefit from corporate tax reform and a generally growing global economy.
The firm books approximately 40% of its revenue from outside the United States, mostly in Europe, which should also do well over the next few years as EU businesses benefit from economic growth and merger activity.
Telecom companies also provide high payouts that tend to increase over time. Communications companies have high capital expenditures but are also protected by high barriers to entry and government regulations. As a result, cash flows are consistent and can be paid out as income to investors.
AT&T Inc. (NYSE:T) paid out 91% of its income over the last year and currently yields around 5%. The company’s acquisition of Time Warner brings revenue diversification an unmatched scale versus other telecom providers. That should mean cash flows sufficient to invest in future growth as well as maintain a sizable dividend.
Not only does AT&T sport a very attractive and stable dividend yield but it also regularly repurchases shares. This, along with consistent sales growth and scale advantages over peers, should help drive shares higher over the long-term as well.
Risks To Consider: Dividend payouts may be cut during periods of economic weakness, though companies that have prioritized cash payouts tend to reinstate their payments when sales return.
Action To Take: Protect your dividend income by holding high-yield stocks in tax-advantaged IRAs and Roth IRAs. Consider the names mentioned above as a starting point for building out your portfolio.
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