Investing in solid companies that pay dividends has traditionally been touted as an excellent strategy for investors looking to build wealth over time. The thinking here is that the lucky investor gets a double whammy in his portfolio. In addition to the appreciation on the stock, he gets to pick up a dividend payout.
Take Citigroup’s stock for example (NYSE: C). As of the end of the second quarter of 2014, the company’s stock was up 7.51% exclusive of dividends. If you add in the dividends, the stock was up 7.59% — a conservative showing if you consider the wild performance of the S &P. Still, Citigroup’s stock reveals not all that bad a performance over a six-month period.
Can we say anything definitive then about stock-dividend strategy from this one example? Is it a good idea? One answer to the question, like the answer to any question about investing in stocks, is it depends on the stock. And as with any generalization, there’s usually an exception.
You don’t need to be much of a stock analyst to realize that, over time, you’re better off with a stock that consistently yields 10% return on your investment without dividends than a stock that yields, say, 6.5% including dividends.
But even if you choose only solid company stocks that pay dividends (Citigroup, Coca Cola, Pfizer, for example), it’s better to do so understanding the dynamics involved. While companies like to point out that they’re sharing the benefits of their good times with you by issuing dividends, you might have other ideas once you think it through.
In his September 3, 2014 Forbes article, financial planner/writer John Girouard points out that if you hang in for the long haul, your dividend-paying stock might play out just fine. But when you start to move things around during the interim, you could be in for a surprise.
Unless you buy your dividend stocks in a tax shelter, you’ll be paying taxes on reinvested dividends at the IRS ordinary tax rate rather than the capital gains income tax rate when it comes time to sell. This could mean a difference between 20% vs. 36% or 39.6%, depending on your tax bracket.
While short-term traders (in the market for less than a year) have always been subject to a higher tax rate, those with dividend stocks are not encouraged to move asset classes or shuffle stocks in their portfolio. So if you do decide to invest in dividend stocks, pick those you intend to live with for a longer period – say 10-15 years – to avoid frequent IRS penalties.