Dividend stocks pay you to own them. But is there a catch? Sort of. Stocks that pay dividends have their downsides, or traits that may run contrary to your financial goals. Read on to learn about four of these traits and how to evaluate whether dividend payers fit within your investment strategy.
1. Taxable income
Dividend stocks produce taxable income unless you're holding them within a tax-advantaged account like an IRA or a 401(k). If you don't have an account that defers taxes on earnings, you will pay taxes annually on the dividends you receive. This is true even if you reinvest those dividends.
Most dividends paid by U.S. companies are taxed as long-term capital gains. In 2022, that tax rate is either 0%, 15%, or 20%, depending on your income. Higher income households may also owe a 3.8% surtax on net investment income.
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Stocks that don't pay dividends can be far more tax-efficient, depending on your trading habits. This is because you don't pay taxes until you realize a gain -- which happens when you sell.
You could be sitting on Amazon (NASDAQ: AMZN) shares you bought for $40 apiece in 2005, for example. Although those shares are trading above $2,000 now (ahead of a big stock split next month), you don't owe taxes on that position until you sell.
2. Lower share price appreciation
Dividend stocks generally don't appreciate as quickly as stocks that don't pay dividends. There are two factors here. One, share prices are driven by the investment community's evaluation of the stock's total return potential. Total return includes dividends and share price appreciation. A stock that doesn't pay dividends will deliver its return entirely via appreciation. Dividend stocks split their returns between shareholder payouts and appreciation.
And two, companies that can fund dividends reliably are established and predictable. These stocks don't exhibit the explosive earnings growth that can drive extreme share price appreciation. They tend to follow the slow-and-steady path instead -- growing less in strong markets and falling less in weak markets.
If you prefer high-growth potential over stability, dividend stocks aren't for you.
3. Better with a longer time line
Dividend-paying stocks are well-suited for a long investing time line. As noted, they can be more or less impressive in the short term, depending on market climate. But they tend to prove their value over decades with reliable growth -- assuming you reinvest those dividends.
For context, the total annualized 10-year return on the S&P 500 Dividend Aristocrats Index is a respectable 13.80%. This index includes some of the most reliable dividend payers. Specifically, Dividend Aristocrats are S&P 500 companies that have raised their dividends in each of the prior 25 years.
4. Cash flow or ongoing investment
Dividend stocks pay you in cash or more stock. You may not want either. Cash can be problematic if you spend it in ways that don't contribute to your financial goals. And if you aren't interested in increasing your stake in that company, reinvesting the dividends doesn't make sense either.
Good or bad, depending on your goals
Dividend stocks are ideal for buy-and-hold investors who can keep those positions in a tax-advantaged account. They're also appropriate for investors who want to build a passive income source over time.
But these income generators have disadvantages. When held in a taxable account, dividend stocks will raise your tax bill. Plus, their growth rates are often mundane, particularly when the market is expanding. If you manage taxes closely or like investing in "the next big thing," then dividend payers may disappoint.
The broader takeaway is straightforward: Any investment opportunity either contributes to your goals or distracts from them. You'll find success by focusing on the contributors and steering clear of the distractors.
