Written by Greg Palacorolla, CFP®
One of the biggest challenges for families as they approach retirement is how to adjust their lifestyle to align with their significantly reduced level of income. For many, social security is their sole source of income. Can you maintain the same lifestyle that you are accustomed to making only a few thousand dollars per month? Some are lucky enough to receive a pension from their employer (these plans are scarce for the millennial generation) which they can combine with their social security payments to support themselves.
However, often times, even these two monthly income sources do not equal your typical paycheck, which is what you’d sculpted your lifestyle around. So, what do you do? You have two options: Consolidate your living expenses to match this reduction in income. Or, begin saving at an early age and throughout your career, accumulate an investment portfolio, and invest in companies that will provide you with one of the most underrated sources of retirement income: Dividends.
What Is a Dividend?
A dividend is a distribution of a portion of a company’s earnings, decided by the board of directors, to a class of its shareholders. Dividends are typically paid by large, mature companies that are no longer seeking ultra-high growth, but prefer to grow the wealth of their shareholders by allowing them to participate in the corporate profits. These distributions are typically paid as cash, but could be in the form of additional shares of stock.
The frequency of company dividends are determined on an individual basis – most are paid out quarterly, but some distribute monthly, semi-annually, or annually. Also, this payout is not affected by the fluctuation in the stock price. That’s right, even if the stock price declines by 10%, you are still paid your quarterly dividend. In addition, most companies tend to increase their dividend regularly as corporate profits continue to grow.
Similar to a cost of living adjustment on your social security payment, an annual increase in a company dividend serves as inflation protection on this piece of your retirement income. The average dividend yield of the stocks in the S&P 500 index is about 2.4%. However, many high-quality, publicly traded companies yield 4-5% per year. Imagine building a portfolio of blue-chip, dividend-paying stocks that pays you 4%? That’s $40,000 per year on a $1,000,000 portfolio, regardless of the price of the underlying stock.
Reinvesting the Dividends
A paramount challenge in dividend investing is accumulating the assets required that will yield you a meaningful amount of income. A great way to expedite the growth of your portfolio is through the reinvestment of dividends. As stated earlier, dividends are usually made as cash payments. You have the option to deposit that cash into your portfolio or reinvest it into additional shares of the company.
For example: You own 200 shares of company XYZ. The share price of XYZ is $100 with a dividend yield of 4%. Therefore, quarterly dividend is $1 per share (4% of $100 = $4. Divided by 4 = $1). Since you own 200 shares, you will receive $200 each quarter. With the election to reinvest the dividends, rather than receiving $200, you will purchase two additional shares of company XYZ. After the payout, you now own 202 shares. Next quarter, your quarterly dividend will be for $202. Over the course of a year, the power of compounding is evident. Assuming the price of the company XYZ is unchanged ($100), you now have the potential for price appreciation on the $20,800 investment. However, you have a definitive 4% dividend on that same investment regardless of performance of the stock price.
To encourage long-term investing, the IRS grants preferential tax treatment on “qualified” dividends. Qualified dividends are taxed at long-term capital gains tax rates, which range from 0% to 20%, depending on your ordinary income rate. These rates represent a significant reduction compared to ordinary income rates that range from 10% to 39.6% A dividend is considered qualified if the investor holds the underlying stock for 60 consecutive days of the 121 days centered on the ex-dividend date. The ex-div date is the date which you must be a shareholder of the stock to be eligible to receive the dividend.
If a shareholder just wants to buy into the position a few days before the ex-div date to collect the payment, they are able to. The payment will just be taxed as ordinary income. It is important to note that the price of the stock is adjusted down on the ex-dividend date for the amount of the dividend payout. Therefore, you cannot just buy the position a day before the ex-div date only to sell it the day after.
How Geier Asset Management Assists
You’ve worked your entire career to put yourself in a financial position to live comfortably in retirement. When that day comes, the difficult part—years of saving—is complete. We are here to help build a well-diversified portfolio built around retirement income. A portfolio structured around blue-chip, multinational companies that reward their shareholders with dividends will be at the core. In addition, managing the tax implications of the portfolio in retirement is crucial. Whether it’s minimizing capital gains, ensuring the dividends are qualified, and mitigating the income taxes owed on withdrawals from 401k’s and IRA’s, comprehensive tax planning is nearly as important as effective portfolio management. Our holistic retirement income planning approach may be the perfect fit for you.
© Geier Asset Management, Inc. March 2016. Greg Palacorolla is the Director of Wealth Management for Geier Asset Management, Inc., a Registered Investment Advisor. The above blog reflects the opinions of Mr. Palacorolla and not necessarily the firm. Any advice given is general in nature and investors must consider their own individual circumstances. Past performance is no indicator of future performance.The firm makes no warranties or representations of any kind relating to the accuracy or timeliness of the information provided.