Q: The market declines bother me, so I’ve been looking for safer places to invest. I’ve been reading a lot about stocks and funds that pay dividends. Should I focus on dividend-paying companies?
A: Dividends are declared by the Board of Directors and may be modified at any time. Companies that pay dividends may decide to stop paying them to shareholders for many different reasons.
In 2008 the S&P 500 had a dividend yield of 3.23% and that yield decreased to 1.87% the next year. There are no guarantees and trading stocks is a taxable event.
High dividend yields may also be found in profit-challenged stocks or troubled sectors. It’s a delusion to assume that an expensive car means the owner is loaded; there may be huge debt attached to it.
Recently a federal judge ruled that lawsuits against 3M company can proceed despite the bankruptcy of the 3M subsidiary. Interestingly, the company paid a dividend even though their share price is off about 30% this year and 50% from its record high in 2018.
General Motors had a dividend yield of 10% as the stock plunged from over $60 in 2003 to under $20 in 2006. We have similar examples with Kodak, Radio Shack and Washington Mutual — once the largest savings and loan institution in the U.S.
Buying a dividend-paying stock at the wrong time causes terrible tax consequences. Check to see if a stock is close to the ex-dividend date, then check the record date and wait until the stock pays the dividend and the price drops. Missing this detail will cause an immediate tax hit as well as a drop in the stock price.
Dividend distributions come in two flavors: ordinary and qualified. Taxpayers in the 22% marginal bracket pay a preferred 15% tax rate for qualified dividends held more than a year. This is taxed the same as realized long-term capital gains, only it’s out of your control. 2021 was a big year for surprises with dividends and capital gains.
Ordinary dividends are taxed as ordinary income, in this example the 22% marginal rate. Even when reinvested, dividends are still taxed when they are issued. Consider using distributions to rebalance a taxable portfolio instead of reinvesting them.
Asset location may minimize taxes and is done by placing tax-inefficient investments, like dividend-paying stocks and Treasuries indexed for inflation, into tax-deferred accounts like IRAs.
Value stocks typically pay higher dividends and have a lower price-to-earnings ratio. Growth stocks often have higher market appreciation and often don’t pay dividends. Having a mix of both keeps the portfolio diversified and able to weather all economic conditions.
Investing in inexpensive index funds as part of a total return strategy creates a mix of large and small as well as value and growth stocks. This also avoids the risk of an overweight stock holding. I repeat: The greatest risk to any portfolio is a large holding in any single stock position.
Fixed income has an important place in a diversified portfolio. Consider high quality/shorter bonds and recently rates on CDs are much more attractive. Don’t overlook small-cap stocks since large-cap stocks were once small.
Don’t limit yourself to only one source of income; dividends are good but so are capital gains and market appreciation. It’s not what you earn; it’s what you get to keep. Dividends that are taxed as ordinary income are not tax efficient.
A total return strategy provides more diversification thus less risk. Owning only dividend-paying stocks or funds may result in your portfolio missing out on other important asset classes, like growth companies that are investing in research and development.
Diversify, pursue a total return strategy, and manage and locate investments in different portfolios for tax efficiency. The eventual goal is to create a withdrawal plan for sustainable income that will result in a peaceful and fun future retirement.
Mary Baldwin, CFP®, is a fee-only financial planner at Buckingham Strategic Wealth in Indian Harbour Beach. Contact her at 321-428-4555 or email@example.com.
For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. The opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Strategic Wealth®. R-22-4250
This article originally appeared on Florida Today: Stock market yo-yo has me worried: Tell me about safer investments