An IRA is an excellent alternative to a 401(k) plan as it provides tax benefits. It is a long-term savings account used by many people to save for retirement. Experts preach dividend stocks to be one of the best long-term investments, so is it wise to have them in your IRA?
You should have dividend stocks in your IRA, especially if you reinvest the dividends. However, having dividend shares in a traditional IRA can have some harsh tax implications when you want to withdraw your money. That’s why Roth IRAs are more suitable to have dividend stocks.
In this article, you’ll learn more about dividend stocks and how you can include them in your IRA. I will also give reasons why dividend stocks are a great choice to have for an IRA portfolio.
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Table of Contents
3 Reasons Dividend Stocks Are Great For IRAs
Dividend Stocks Are a Great Long-Term Investment
Dividends make a significant portion of the returns from the stock market.
Although the dividend yield may seem insignificant at face value, the returns you will get over a more extended period will significantly improve your portfolio.
These long-term gains are exactly why dividend stock is an excellent option for an IRA. Even if the stock market falls, this will rarely affect your dividends, as they will still be paid regularly. Additionally, dividend stocks are more stable and lose less value than regular growth stocks during a bear market.
The earlier you start your IRA and start buying a dividend stock, the better.
Remember that they are not ideal in the short term, so if your IRA is close to maturing, it might be too late to start buying dividend shares.
Dividend Stocks Are Known To Deliver Compounding Growth
When you own dividend stock, appreciation of the value of the individual shares you own isn’t the only way to make your IRA more valuable. When dividends are reinvested back into the account, the strategy of dividend investing can have a significant compounding effect.
For IRAs, since you won’t be able to withdraw your money immediately anyway, dividends are automatically reinvested back to buy more shares.
Once your IRA matures, which can take 40 years if you started your account at 30, you would experience a significant increase in your holdings thanks to the compounding effect of reinvesting dividends.
The Dividend Data channel on Youtube gives a great representation of how powerful compounding can be with dividend stock:
Should You Reinvest Dividends?
Most brokerages allow you to set up an automatic reinvestment plan for your dividends. With IRAs, you should do this as it can significantly increase your profit in the future.
The only exception is if you are already taking IRA distributions or plan to take them soon.
Since the stock market can be very volatile in the short term, it wouldn’t be wise to invest your dividends and watch them shrink during a market downfall. For a shorter time horizon, it is smarter to hold the dividend in cash.
Dividend Stocks Are Relatively Safer Stock Market Investment
Those who want to start a savings account might be reluctant to invest their savings into
stocks because of the risks involved in doing so. With an IRA, safe investments are crucial as you don’t want to be putting your savings into high-risk stocks that can potentially lose everything you saved.
When it comes to the stock market, there are fewer investments that are safer than dividend stocks. These stocks are top value companies, many of which have increased their dividends each year for the past 25 years, which are known as dividend aristocrats.
The chances of these stable companies collapsing are very slim.
However, it would be best to still be careful and only invest in long-lasting companies that have increased their dividends over an extended period.
When it comes to determining how much of your IRA portfolio should be in the stock market, a general rule of thumb is to take 100 and subtract it from your current age. So, if you’re 30 years old, 70% of your IRA portfolio should be in stocks.
Why Should You Include Dividend Stocks in Your Portfolio?
Now that we have learnt why dividend stocks make a great addition to your IRA portfolio, let us briefly discuss a more fundamental question – Why should you invest in dividend stocks at all?
Dividend stocks, in essence, are stocks from companies that are known to pay regular dividends to their shareholders. These companies are able to pay dividends regularly because they usually are well-established companies that make large profits and have a stable future, and thus can give some of it back to the shareholders.
Therefore, investment in these companies is relatively low risk and these stocks are also great to generate healthy cash flows for their investors.
Most companies make these payments quarterly.
The payments should transfer to your account automatically. The dividend yield of your shares can change and tends to increase in today’s market.
Traditional IRAs vs. Roth IRAs for Dividend Investing
Not all IRAs are created equal, and they each have different implications for dividend investing, mainly related to taxation. Despite some differences, IRAs are inherently very similar, so it is essential to understand where the slight differences come from and how they apply to your savings plan.
So, let’s briefly explain how traditional IRAs and Roth IRAs work:
- Traditional IRAs allow for the investment of pre-taxed cash into a savings account that can grow tax-deferred until you withdraw it in retirement. In retirement, the withdrawal is taxed based on the owner’s current income tax bracket. Contributions are limited to $6,000 per year for people under 50 and $7,000 for 50 or older.
- Roth IRAs allow for tax-free withdrawals if certain conditions are satisfied. Unlike traditional IRAs, a Roth IRA is funded by after-tax cash. Once you start withdrawing funds from your account, the money is tax-free. Roth IRAs are ideal if you think that your tax rate will increase in retirement.
The Roth IRA contribution limits are the same as in traditional IRAs, but people earning more than $140,000 a year aren’t allowed to open a Roth IRA.
Which Is Better for Dividends? Traditional IRA or Roth IRA?
Both traditional and Roth IRAs can be a great way to achieve growth through dividends. If you expect your tax rate to be higher in retirement than it is today, holding your dividend shares in a Roth IRA is a better idea.
Roth IRAs are also better if you plan to live off your dividends in retirement. The money will accumulate tax-free over the years, and you still won’t need to pay tax when you take it out.
On the other hand, traditional IRAs will still allow for tax-free growth over the years, but when you withdraw the money, you will have to pay tax, which can decrease your profit significantly.
Are Individual Dividend Stocks Better Than Mutual Funds For IRAs?
If you aren’t a seasoned investor or professional, filling your IRA with individual stocks and bonds can be a costly mistake. For optimal diversification, it is best to invest in a mutual fund or an ETF.
These funds can contain not only dividend stocks but other securities as well.
With thousands of mutual funds out there, you can select the one that works best for you based on your risk tolerance. There are dividend funds that will distribute your money into different dividend stocks, which is a much safer alternative than putting everything into one or two companies.
When selecting a fund to invest in for your IRA, you should look for one actively managed.
Since most ETFs track a particular index, they are usually passively managed, so you should generally stick to mutual funds for your IRA. However, adding a dividend ETF can also be beneficial.
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Conclusion
Dividend stocks are an ideal option for an IRA and are a safe long-term investment that can significantly improve your portfolio, especially if you reinvest the dividends.
Roth IRAs are a better option than traditional IRAs for dividend holding since they allow you to withdraw your earnings tax-free once your account matures. For risk management, it is better to invest in dividend funds rather than individual stocks.
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