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Tue. Sep. 29, 2009

How To Maximize Your Dividend Stocks’ Earnings *

What makes investing in dividend stocks so intriguing is the power of compound dividends. We all know that compound interest is what occurs when interest previously earned is added to the principle and is considered when calculating future interest – i.e. earning interest on interest. Compound dividends are like compound interest, but much better.

Like compound interest, reinvested dividends will earn “dividends on dividends”, but it doesn’t stop there. In addition, great income stocks grow their dividends each and every year, so that means your dividends are growing even if they were not reinvested.

As our detractors like to point out, there is a dark cloud that hangs over dividend stocks in the form of income taxes. Each year the government has their hand out wanting their cut of our dividend income. For most investors in the U.S. investing in stocks with qualified dividends the tax is limited to 15%. But still that is 15% that can’t be reinvested.

One way to minimize the negative effect of taxes is with the use of tax advantaged accounts, such as a Roth IRA, to house a portion of your income portfolio. The beauty of using your Roth IRA as a income investment account it that you will never have to pay taxes on the dividends earned. Avoiding the taxes will have a significant affect on your account balance over time.

Consider a hypothetical case where $3,000 is used top purchase three stocks each year for 10 years in a Roth IRA and a taxable account. The accounts are opened on the last trading day of 2008 and dividends and the the year’s contribution are reinvested on the last day of the year. I selected three dividend companies, Chevron Corp. (CVX) – AnalysisConsolidated Edison Inc. (ED) and Genuine Parts Co. (GPC) – Analysis, that grew dividends over the last 10 years. Here are the results of the analysis:

Value At Dec. 31, 2008
Account Type
IRA Taxable $Diff % Diff
Chevron Corp. (CVX) 12,403.36 12,168.68 234.68 1.93%
Consolidated Edison Inc. (ED) 13,108.02 12,575.85 532.17 4.23%
Genuine Parts Co. (GPC) 14,395.88 13,993.27 402.6 2.88%
Total 39,907.26 38,737.81 1,169.46 3.02%

Click here to see the spreadsheet used to generate the above results.

The use of of a tax advantaged IRA saved this hypothetical portfolio $1,169.46 or 3.02%. Over time this difference would continue to grow, and would be quite substantial for a person that opened a Roth IRA in their 20′s and held it 40+ years into their 60′s at retirement.

Full Disclosure: Long CVX, ED, GPC. See a list of all my income holdings here.

(Photo: Photo Credit)


5 Responses to “How To Maximize Your Dividend Stocks’ Earnings *”

  1. I think it is wise to NOT have stocks in IRA’s, 401K’s, etc. Our tax laws have all kinds of benefits for stocks.

    I ONLY want CD’s or similar products in them. And, yes CD’s are investments as long as they are longer term and have favorable early withdrawal penalities, hence have the double purpose of being long term products and at the same time serving as liquid cash to take advantage of better yields, etc and not being tied to a specific CD for its duration. The reason I also think bonds don’t belong in IRA’s, 401K’s, etc because of favorable capital gain/loss tax laws.

  2. This is a great point, overlooked by many. My Roth IRA is set up with a discount broker and all dividends are automatically reinvested in fractional shares. Not only is it advantageous from a growth standpoint, but I don’t have to deal with the nightmare paperwork I would is a taxable brokerage. After all, who wants to keep track of the cost basis of one stock purchasing fractional shares 4 times a year, much less multiple stocks. Figuring the capital gains tax liability when you sell would take up all of your retirement years!

  3. Welcome Britt. Thanks for stopping y and commenting.

    Best Wishes,
    D4L

  4. Tax Lawyer says:

    I’ve been included in taxes for lengthier then I care to admit, both on the individual side (all my working lifetime!!) and from a legal stand since satisfying the bar and following up on tax law. I’ve offered a lot of advice and rectified a lot of wrongs, and I must say that what you’ve put up makes utter sense. Please carry on the good work – the more people know the better they’ll be armed to deal with the tax man, and that’s what it’s all about.

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