Investors love dividends, and for good reason. Reinvested dividends have made up 69% of the S&P 500’s total investment returns since 1960. Some of the world’s most famous investors, including Warren Buffett, routinely praise dividends.
Arguing against a dividend-focused investment strategy might seem outlandish in this light. However, dividends have some drawbacks that investors might not realize or discount more than they should.
Here is why dividends might not be the best passive income strategy and how to tell what’s right for you.
Understanding the nuts and bolts of dividend investing
First, it’s essential to understand the ins and outs of what dividends are. Companies have a couple of choices in how they spend their profits. A company can either reinvest earnings into the business to grow, pay down debt, or accumulate cash on its balance sheet. Or a company can return profits to shareholders by repurchasing their stock or paying a dividend.
Generally, a company begins paying a dividend once its business matures and doesn’t need to invest so much for growth. It’s a way for management to share success with shareholders and reward them for investing in the company. Investors love dividends because they represent cash in hand, real profits they can save or spend — even use to pay for living expenses.
Dividend investing can be rewarding, but it’s not as straightforward as it sounds. For starters, you need a lot of capital to generate significant dividend income. A 3% yield on a $1,000,000 dividend portfolio will pay you $30,000 annually. That’s great, but it likely won’t cut it as a stand-alone retirement plan. Starting early and investing often can help you get that compounding snowball rolling downhill.
Dividends are not tax efficient
Many investors don’t realize how dividends are taxed. Dividends are taxed yearly, even if you don’t sell your shares. While people can avoid taxes if their income is low enough, most people accumulating stocks (those saving for retirement) probably work and might sit in a higher tax bracket.
Dividends also suffer from a problem called double taxation, meaning a corporation pays taxes on its profits before paying you, and then the government swoops in and taxes your dividends when you file your income tax. Remember how I mentioned Warren Buffett at the top? His holding company Berkshire Hathaway doesn’t pay its shareholders a dividend, and that’s intentional.
You can use retirement accounts like a Roth IRA to shelter your dividends from taxes, but it’s not easy. Most retirement accounts limit your annual contributions, bottlenecking how much you can accumulate. You could be forced to hold dividend stocks in a taxable brokerage account instead.
How you could benefit from a total returns strategy
So what’s the solution? You could consider adding high-quality growth stocks to your investing strategy. These companies won’t pay you for holding them, but they’re plowing every dollar back into the business for growth. That means a higher share price for investors. Retaining all its earnings makes non-dividend payers more tax efficient because you only pay taxes when you sell the shares.
A growing company can continually reinvest its earnings, compounding its investment returns as share price gains. You can slowly sell shares for cash as needed. But don’t go overboard; growth stocks are typically more volatile, so keep that in mind when planning your portfolio.
This is a reminder that you don’t need to be all-in on the dividend train to find long-term success investing. Adopt a strategy that fits your time horizon, goals, and risk tolerance, and ask a professional advisor if you’re unsure about what you’re doing. The most crucial factor in your success will be working toward a goal and consistently showing up over the long term.
Justin Pope has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Berkshire Hathaway. The Motley Fool has a disclosure policy.
https://www.fool.com/investing/2023/04/17/are-dividend-stocks-really-the-best-passive-income/
