I’ve tried many different types of investments with my Individual Retirement Account, including bank accounts, Ginnie Mae bond funds, growth stock mutual funds, growth stocks, and income stocks. Of all the alternatives, stocks that pay high dividends are the way to go.
The problem with bonds and bond funds is that there is no inflation protection, with a couple of exceptions: convertible bonds and Treasury Inflation-Protected Securities (more commonly referred to as TIPS). Bonds pay a fixed amount upon maturity, and that’s it.
Of course, bank savings accounts and certificates of deposit are paying virtually nothing. You are lucky to get one percent from a CD these days.
So now we narrow it down to growth stocks versus income stocks. Quality growth stocks that don’t pay dividends can perform well over long periods of time, but the problem takes place when the stock drops and you don’t expect it to recover. You end up taking a loss but you can’t deduct the loss for tax purposes. Outside of an IRA, you can use your capital losses to offset any capital gains, and any excess losses up to $3,000 per year can be used to offset any other income.
Another issue with putting a growth stock in a regular IRA is that if you sell the stock at a profit, you end up converting capital gains to ordinary income when you eventually withdraw the funds. The capital gains tax is lower than the rate on regular income, so you lose out on the capital gains tax benefit.
That leaves income stocks. Stocks that pay dividends have a couple of advantages when held in a retirement plan. First, the dividend income can increase over time, giving some inflation protection. Second, because these are stocks and not bonds, the share price has the potential to rise in the future, providing additional inflation protection.
Fortunately, there are plenty of stocks with long term track records of dividend increases. According to the free list at WallStreetNewsNetwork.com, there are over 20 stocks that have increased their dividends every year for more than 30 years. One example is Kimberly-Clark (KMB), the maker of Kleenix tissues, Cottonelle toilet paper, and Huggies diapers, which pays a superb yield of 3.9% and has raised its dividend every year for 38 years. Another top dividend stock is Target (TGT), the second-largest discount retailer in the United States. It sports a yield of 2.4% and has bumped up its dividend for an incredible 43 years.
In addition to the dividend increase track record, I also look at the dividend coverage. In other words, what is the cash flow coming in versus the total amount of dividends paid out. If the cash flow has been dropping to the level of the dividend payout, a dividend cut may be in the cards.
The nice feature about income stocks is that if the stock drops, income is still coming in, and assuming it is a solid company, the stock should eventually recover. If the stock stays the same, income keeps coming in. And if the stock goes up, income comes in along with capital gains.
Full disclosure: Author didn’t own any of the above stocks at the time the article was written.
By Fred Fuld, publisher of Stockerblog.com