Dividends are payments to shareholders from a company’s profits. Growth stocks and start-ups usually don’t pay dividends because they have to reinvest earnings to keep growing at a high rate. However, once a company reaches a certain size, its high margin for growth generally decreases, so companies will pay dividends to entice investors to continue investing in them.
Dividend stocks aren’t as flashy or attention grabbing as growth stocks tend to be, but there’s no denying that they’re just as, if not more, lucrative for investors.
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It pays to hold onto dividend-paying stocks
A big part of the appeal of dividends is that they’re close to guaranteed income, and investors don’t have to worry so much about a stock’s price movements because they’ll still receive their dividend. . Has the stock price increased by 10%? Expect your dividend. Is the stock price down 10%? Expect your dividend. Share price flat? Expect your dividend.
There are situations where a company can cancel its dividend — such as Delta (NYSE: DAL) at the start of the COVID-19 pandemic – but if you’re investing in Dividend Aristocrats, you don’t have to worry too much about this issue. Dividend Aristocrats are S&P 500 companies that have successfully increased their annual dividend payout for at least 25 consecutive years. The Dividend Aristocrat designation gives investors confidence that a company has the financial resources to overcome broader economic issues while producing good returns.
Dividends add to compound earnings effects
Are you looking to build up your stock market wealth? Learn to appreciate the power of compound earnings. Compound income occurs when the money you earn on your investments begins to earn money on its own. Compound earnings on their own are powerful, but the effects increase when you reinvest your dividends in the stocks that paid them. And it doesn’t take much effort; you can sign up for your broker’s dividend reinvestment program to have it automatically do this for you.
Let’s take it Vanguard High Dividend Yield ETF (NYSEMKT: VYM) for example. Since its inception in 2006, the ETF has returned just over 8% per year. Imagine investing $500 per month in the fund and receiving the same returns for 20 years. At the end of this period, your investment would be worth over $274,500. If we assume that its current dividend yield of 3% remained constant during this period and you reinvested the dividends, your investment would grow to over $385,200 after 20 years.
It’s usually best to delay your cash dividend payments until retirement to give it time to accumulate and increase your stake in the stock that pays it. A 3% dividend yield might not be much today ($300 for $10,000 of value), but once you’ve built up a significant stake over a career, it can be excellent additional retirement income.
If you are eligible to contribute to a Roth IRA, you should definitely consider taking advantage of it. Unlike a 401(k) or traditional IRA, a Roth IRA account allows you to make tax-free withdrawals in retirement. Most people fall into the 15% capital gains tax bracket, which means that for every $100,000 you have in capital gains, you will owe $15,000 in tax. Depending on how much you can save in a Roth IRA, tax-free withdrawals could easily save you up to five figures.
Using our Vanguard High Dividend Yield ETF example, if you had $385,000 in the fund with a constant 3% dividend yield, it would pay $11,550 in annual dividends. If you held it in a Roth IRA, every penny of the dividend payouts (as well as any other amount you withdraw) would be yours. If you held it in a regular brokerage account, you would pay taxes on the dividend payouts every year.
Any money not paid in taxes is money you can use to enjoy your retirement.
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Stefon Walters has no position in the stocks mentioned. The Motley Fool has positions in and recommends Vanguard High Dividend Yield ETF. The Motley Fool recommends Delta Air Lines. The Motley Fool has a disclosure policy.