“The best time to plant a tree is twenty years ago. The second best is now.” Chinese Proverb
Over the last few months, I’ve changed my investment strategy for the little bit of after-tax money I have available to invest outside of retirement plans. It’s worth noting before going any further that it almost always makes more sense to put available money in tax-deferred or tax-free retirement savings vehicles, such as the Roth IRA, before investing outside of these plans.
I take sort of a dual approach, recognizing that I may in fact need access to some of my savings and investments before I reach 59 1/2. Roth IRA contributions are available to withdraw any time since they represent investment dollars that have already been taxed. However, I’d like to let the Roth IRA grow as long as possible without removing contributions.
Investing Money in Taxable Accounts: The Options
When it comes to investing money in taxable accounts, the options are endless. Here’s a short list:
- Mutual funds
- Individual stocks
- Money Markets
Each of these vehicles offer different degrees of risk and potential investment reward. Obviously, in a low-rate environment like the one we are in today, cash-based investments don’t offer much in the way of return. Most money markets are hovering around 1.5% APY, and regular savings accounts and short-term CDs are even worse.
I’m generally a fan of mutual funds, and have most of my retirement in Vanguard funds. However, after dabbling in mutual fund investing for our taxable accounts, I’ve found they don’t offer the element of control I like to have over that money (deciding when things are sold to take the tax hit, etc.).
Individual stocks can also be promising, but on the risk scale these are near the top. I’m won some and I’ve lost some, and in all honesty, I’ve done well just to break even on most of my trades over the last few months. Any small gains I earned were eaten up by broker fees, the rest in capital gains taxes. Seemed like a lot of work for a relatively small reward (in most cases).
Dividend Reinvestment Plans
I still like the idea of investing in particular companies that I believe will do well over the long term. Companies that have been around for a few decades, cranking out profits and returning some of them to shareholders.
These large, blue-chip growth companies can typically withstand a market meltdown, and often experience modest gains in bull markets as well. But their real beauty lies in their dividend. It is that dividend that spins off consistent income to investors quarter after quarter that makes them so attractive.
Many of these companies offer a direct purchase dividend reinvestment plan, meaning you can buy stocks directly from a plan administrator, often for much lower commissions than you would find at brokerage.
After an initial purchase you can set up an automatic withdrawal from your checking or savings account to purchase shares (even fractional shares) of the company. Dividends earned may be reinvested to purchase more shares, providing a compounding effect that can quickly grow the number of shares owned.
Many years down the road, once we’ve accumulated a large number of shares in a particular company, we may opt to start receiving dividend payouts in cash. Most transfer agents allow a direct deposit to your checking account.
A Working Example
Imagine you are 55 years old, and 30 years ago you dropped a couple thousand dollars into a stock like Procter and Gamble (PG). That single investment would be worth more than $123,247 today. You would have started with 27 shares, but by reinvesting dividends, you now would have over 1,980 shares. *I found that example on the Fool.com website, a great source for dividend investing info.
Proctor and Gamble currently pays shareholders an annual dividend of $1.93 per share, or roughly $0.48 per share each quarter. That means every three months you would be receiving a check for $950. Doesn’t sound like much?
What if you had invested a couple thousand back in 1980, and then decided to add $100 a month to your holdings all along. The math is a little tricky, so we’ll just use some very rough estimates. Let’s assume that continuing monthly investment allowed you to add another 3,000 shares, so you now own 5,000 shares of Procter and Gamble. Each quarter, you would receive a dividend payment of $2,412.
Now imagine you took the same dividend investing approach with a couple other favorite holdings…maybe something like Coca Cola and Exxon Mobile. You can see how a sustained investment in a handful of high-yield dividend stocks could spin off a comfortable income down the line.
What are the Risks?
I certainly don’t mean to present this as a zero-risk investment, because there are risks. One of these companies could go bankrupt and you could lose your investment. The company could cancel its dividend, as many bank stocks did during the recent recession, or BP did after the Gulf oil spill.
If one of these stocks abruptly cancels its dividend, and you are counting on it for income, you may be forced to sell all of your shares and move them to another investment, which could result in a realized loss or a sizable tax event.
There is also a political risk in the form of higher taxes. Qualified dividends are currently taxed at the long-term capital gains rate, but there is a move to count these earnings as ordinary income, which could significantly increase the tax liability – hitting those relying on dividend income the hardest.
For these reasons, it makes sense to make this only a part of your overall investment strategy. I would still invest in well-diversified mutual funds, bonds or bond funds and consider owning some assets outside of the market (real estate, farmland, silver, etc.).
How to Pick a Dividend Stock
In terms of stock picking, I recommend checking out listings such as the Dividend Aristocrats, a collection of S&P 500 companies that meet strict criteria to be included on this list, such as:
- Companies must be a member of the S&P 500.
- Companies must have increased dividends every year for at least 25 consecutive years.
- Companies must have a float adjusted market capitalization of at least US $3 billion as of the rebalancing reference date.
- Companies must have an average trading volume of at least US$ 5 million for the six-months prior to the rebalancing reference date.
Source: S&P 500 Dividend Aristocrats factsheet
You may have additional screening criteria to add, but this is a good starting point. The members of this list represent large, stable blue-chip companies, often with world-wide operations and a solid history of producing profits. Many of them are somewhat recession-resistant (think of Proctor and Gamble’s product line – people still buy detergent and cleaners and batteries and paper products in a recession).
Where to Get Started
Most company websites have an “Investor Relations” area with information on shareholder services such a dividend reinvestment programs, direct purchase plans, etc. Most DRIPs are handled through an administrator.
If the company you are interested in investing does not offer a DRIP or direct investment plan, there are other cheap ways to buy dividend stocks. You can always use a discount broker such as TradeKing, Scottrade or Sharebuilder. Sharebuilder even allows fractional share investing so you can purchase a specific dollar amount of a particular security, rather than being forced to buy whole shares (which can be costly for many of these larger companies with high stock prices).
Be sure to consider the various fees charged by a broker versus direct investment plans (a few of these can be costly as well, so don’t just assume a DRIP is cheaper).
If you don’t have thousands to invest, or even if you do, consider starting a DRIP and adding any extra dollars you can squeeze from your budget towards and income-replacer later on. If twenty years from now you could live a frugal lifestyle on passive dividends you’ll be glad you started.
Disclaimer: At the time of this writing, I do not own the individual stocks (PG, KO, XOM, BP) mentioned in this article