Dividend shares pay you for owning them. But is there a problem? Somewhat. Dividend stocks have their downsides, or traits that may conflict with your financial goals. Read on to learn about four of these traits and how to assess whether dividend payers fit into your investment strategy.
1. Taxable income
Dividend shares produce taxable income unless you keep them under a distinct tax account such as an IRA or 401(k). If you don’t have a dividend tax deferral account, you will pay annual taxes on the dividends you receive. This is true even if you reinvest those profits.
Most dividends paid by US corporations are taxed as long-term capital gains. In 2022, that tax rate is either 0%, 15%, or 20%, depending on your income. High-income families may also owe an additional 3.8% tax on net investment income.
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Non-dividend stocks can be more tax efficient, depending on your trading habits. This is because you don’t pay taxes until you make a profit – which is what happens when you sell.
You can be sitting Amazon (NASDAQ: AMZN) Of the stock I bought for $40 apiece in 2005, for example. Even though these stocks are trading above $2000 now (before the big stock split next month), you don’t owe taxes on that position until you sell.
2. Low stock price appreciation
Dividends generally don’t appreciate as quickly as non-dividend stocks. There are two factors here. First, stock prices are driven by the investment community’s assessment of the total potential return per share. Total return includes dividends And the Share price rise. A stock that does not pay a dividend will make its full return through appreciation. Dividend shares divide their returns between shareholder payments and appreciation.
And second, companies that can reliably fund dividends, are created and predictable. These stocks do not show massive earnings growth that can lead to a sharp rise in the stock price. They tend to follow the slow and steady path instead – growing less in strong markets and falling less in weak ones.
If you prefer high growth potential over stability, then a dividend is not for you.
3. Better with a longer time line
Dividend-paying stocks are well suited for a long investment timeline. As noted, it can be somewhat impressive in the short term, depending on the market climate. But it tends to prove its value over decades with reliable growth – assuming you reinvest those profits.
For context, the 10-year total annual return on S&P 500 Dividend Aristocrats It is a respectable 13.80%. This indicator includes some of the most reliable dividend payers. Specifically, Dividend Aristocrats are the S&P 500 companies that have raised their dividends in each of the previous 25 years.
4. Cash flow or current investment
Dividend shares pay you cash or more shares. You may not want to either. Cash can be a problem if you’re spending it in ways that don’t contribute to your financial goals. And if you are not interested in increasing your stake in that company, reinvesting profits also makes no sense.
Good or bad, depending on your goals
Dividend stocks are ideal for buy-and-hold investors who can hold these positions in a tax-enhanced account. It is also suitable for investors who want to build a passive income source over time.
But these income generators have drawbacks. When held in a taxable account, the shares distributed will raise your tax bill. In addition, their growth rates are often normal, especially when the market is expanding. If you manage taxes closely or want to invest in the “next big thing,” dividend payers may be disappointed.
The broader takeaway is straightforward: an investment opportunity either contributes to or distracts from your goals. You will find success by focusing on your stakeholders and avoiding distractions.
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John Mackie, CEO of Whole Foods Market, an Amazon company, is a member of The Motley Fool’s Board of Directors. Catherine Brooke does not have a position in any of the stocks mentioned. Motley Fool has and recommends positions at Amazon. Motley Fool has a disclosure policy.