A Roth IRA is a type of investment account that helps you save for retirement. You pay taxes on the money when you contribute it and in exchange for keeping the money in the account until you retire, you can withdraw those contributions and earnings tax-free.
One popular strategy for people who want to save for retirement is to buy dividend-paying stocks. Dividends are regular distributions of cash that companies give their stockholders. Investors can reinvest those dividends to buy more shares over time, increasing the size of each dividend payment they receive. Once they retire, those dividends can serve as a source of income.
Roth IRAs provide the opposite benefit of traditional IRAs, which let you deduct contributions from your income but require you to pay income taxes on withdrawals.
Roth IRAs are good accounts for dividend investors to use because the dividend payments won’t be subject to income taxes paid by investors on dividends received in a taxable account. Find out more about how dividend investing works and why it might be a good fit for your Roth IRA.
- Roth IRAs let investors grow their savings tax-free.
- Dividends received in a Roth IRA aren’t subject to income taxes.
- Reinvesting dividends into additional shares increases the amount of dividends you receive in the future.
- Many investors use dividends to produce a stream of income in retirement.
How Dividend Investing Works
Dividend investing means buying shares in companies that pay dividends. Typically, these are larger, more established companies that don’t need to spend as much money on expanding their operations.
A common metric that dividend investors look at is dividend yield, which is the ratio of a company’s dividend payments to its stock price. For example, a company that pays $2 in annual dividends and has a stock price of $100 would have a dividend yield of 2%.
Some companies are called blue chips. Blue chips are extremely big companies with a reputation for large, stable dividends and a reliable stock price. The list of blue-chip businesses includes giants 3M, Johnson & Johnson, Coca-Cola, and Disney.
While dividend-paying companies may not experience the significant price appreciation other stocks might see, they offer stable returns through their dividend payments. These payments often happen quarterly.
Dividend investors often choose to reinvest their dividends by buying more shares. This lets them receive a growing dividend payment, which in turn increases the number of shares they can purchase. Over time, compounding returns can lead to significant growth in investors’ portfolios.
For example, imagine a company worth $50, with a dividend payment of 75 cents every quarter (a yield of 6%). Assume the company’s stock price holds steady at $50.
An investor buys 100 shares of the company for $5,000. Their first dividend payment totals $75, and they reinvest it in the company, purchasing an additional 1.5 shares. Their next dividend payment will be $76.125, allowing them to purchase an additional 1.522 shares. The third dividend payment will be for $77.267, letting them buy 1.545 more shares, and so on.
You can use a compound interest calculator to see how your portfolio might grow over time if you reinvest your dividends. The calculation won’t be perfect because stock prices can change over time, but dividend payments also change—so if a stock’s price rises, its dividend might rise also.
Finding Dividend Stocks for Your Roth IRA
Choosing the right dividend stock for your Roth IRA is important if you’re hoping to grow your portfolio over time. Retirement investing means building your nest egg over decades, so you want to buy shares in large, stable companies.
One metric investors look to when trying to identify strong dividend investments is dividend growth. A company that consistently increases its dividend is displaying financial stability. This concept is popular enough that it has led to the idea of Dividend Aristocrats.
A company is a member of the Dividend Aristocrats if it has increased its dividend every year for the past 25 years straight.
You can use a stock screener to identify companies that have a record of dividend growth or that have a high dividend yield. However, keep in mind that a dividend yield that is too high might be a sign of a company in distress or that the dividend is unsustainable.
Also, consider the industry the business operates in. Good picks for stable dividend investments include businesses that can succeed in both strong and weak economies or ones that have a natural ability to weather less-profitable years. Examples include consumer-staples businesses or utilities companies, as demand for these things is relatively consistent over time.
Finding stable companies with good dividends has historically been a strong investment strategy. A few modern Dividend Aristocrats have made many people millionaires in the past. The following are a few examples:
Coca-Cola is a multinational beverage company known across the globe for its carbonated soft drinks. The company was founded in 1892 and has a long history of increasing dividends.
One popular story among dividend investors is that of the town of Quincy, Florida. Many residents were convinced to invest in the company during the 1920s and 1930s because the stock was significantly undervalued, trading for less than the amount of cash it had in its bank accounts.
Over the following decades, Coca-Cola continued to grow at a steady pace and pay regular dividends. Many residents of the town became millionaires. This story is one of the most popular stories regarding dividend investing because residents of the town were able to rely on those regular payments to grow their portfolios and shore up their incomes during poor financial times.
Johnson & Johnson
Johnson & Johnson is another Dividend Aristocrat that is well-known for the stability of its dividend payments.
The company operates in multiple industries, selling medical devices, pharmaceuticals, and consumer goods. Many of its products are staples that people need to purchase in both strong and weak economies. Historically, that has insulated it from the negative impacts of recession and made it a stable investment.
At the time of publication, Johnson and Johnson’s dividend yield is just under 2.5%, its stock price has grown at a pace of 8.87% over the past five years, and its dividend has grown at roughly 6% per year since 2013.
That means investors have seen the value of their shares appreciate and have enjoyed growth in their annual income from the expanding dividend payments.
Should You Invest Your Roth IRA Fund in Dividend Stocks?
Whether you should use your Roth IRA to invest in dividend stocks is a difficult question. It all depends on your personal goals and investing style.
Dividend stocks tend to be more stable than other stocks over the long run, but that doesn’t mean they’re going to retain their value in all situations. For example, during the start of the pandemic, one Dividend Aristocrat ETF saw its value drop by roughly one-third.
By contrast, Vanguard’s bond ETF fell by a much smaller percentage, roughly 6.5%. That shows that dividend stocks aren’t always a good way to avoid market downturns.
At the same time, dividend stocks may not experience the price growth that other stocks, especially small-caps and growth stocks, net. For example, over the past decade, Vanguard’s growth-stock ETF has returned 16.3%, while the Dividend Aristocrats Index has produced a return of 14.05%.
Frequently Asked Questions (FAQs)
Do dividends count toward Roth IRA contributions?
No, dividend payments on shares held in your Roth IRA do not count toward Roth IRA contribution limits. You may contribute up to $6,000 from outside the account in 2022 as long as you meet income restrictions.
What is a dividend yield, and how do you calculate it?
Dividend yield is the ratio of a company’s annual dividend payment compared with its stock price. You calculate it by dividing the annual dividend by the price of one share. For example, if a company pays $1 in dividends per share each year and its shares trade at $30, its dividend yield is $1/$30 = 3.33%.