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) - Analysis, Consolidated 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% | ||||
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)
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