Living off your portfolio’s dividends in retirement seems like a pretty straightforward strategy, you never have to sell your investment, and therefore, you can never run out of money.
But it’s not quite that simple.
Before diving in, let me say I know this topic will ruffle some feathers because dividends are loved by many retirees and a lot of financial advisors, for that matter. Before you dig in and disagree, I’m going to challenge you to read the entire article (or watch the video above) before coming to a conclusion.
The Misunderstanding Around Dividends
So, let me start off by stating that there is nothing wrong with dividends. My issue is that they are misunderstood by many investors. These misunderstandings fall into four categories:
- They’re free money
- They’re guaranteed
- The tax implications
- The diversification dividends stocks allow you to have
Misconception #1: Dividends Are “Free Money”
When people hear dividends, it’s easy to relate that back to a savings accounts.
Imagine you have $100 in a savings account, if it pays out 4% interest, you will have $104 at the end of the year.
Unfortunately, that’s not how dividends work.
Left Pocket/Right Pocket
Let’s say you have $100 in your left pocket, and you decide to pay a $4 dividend to your right pocket. Well, now you have $96 in your left pocket and $4 in your right. You still have $100 in your jeans. No new wealth was created because a dividend was paid out. It’s the same thing in the stock market.
No New Wealth
Let’s say you own 100 shares of ABC stock at a price of $20 for a total of $2,000. If it pays out a $4 dividend, you will still have 100 shares, but now the stock price will have fallen to $16, just like in the example with our jeans. So you will now own $1,600 in ABC stock, and you will have $400 cash in your pocket from the dividend. You still have $2,000 total. If you decide you don’t want the cash and decide to reinvest the dividend instead you can certainly do so. The stock price is now at $16 and if you reinvest $400, you’ll be able to add an additional 25 shares.
You now own 125 shares at $16 for a total of $2,000.
In both scenarios, the dividend was irrelevant to ABC stock’s return.
Now, having said that, the fund may still have some growth, so it is possible that it could grow back to $20, but that’s not guaranteed to happen. Either way, if it does get back to $20, that has nothing to do with the dividend because as we know dividends do not create additional wealth.
But what if I reinvest?
Now, you might be saying to yourself, whenever I get paid a dividend, the stock price doesn’t seem to go down by the same amount. And you’d be correct, in the real world it’s not a one-to-one relation between dividends and share price because there are other factors affecting the price of the stock that day.
Let’s go back to ABC Stock. It’s trading at $20, and it pays out a $4 dividend, so it’s now worth $16. But on the same day, they come up with a new product that’s going to change the world, so its stock price shoots up to $30. It might seem like the dividend actually helped the stock price, but it actually dragged it down by $4 that day. Had ABC Stock not paid out a dividend, it would be worth $34.
Real World Companies
Let’s take a look at the 10 largest companies of the S&P 500 High Dividend Index for the period of Dec 2018 to Oct 2023. The average dividend paid by these companies was $1 per share, and on average, their share prices declined by $1.15 when those dividends were paid. As we know the $1 decrease is simply due to the dividend, but the extra $0.15 difference just due to other factors that were affecting the stock prices that day.
Source: A Slice of Dividend Accounting
Misconception #2: They Are Guaranteed
Let’s move on to the second misunderstanding: dividends are guaranteed. I often hear investors say they don’t care if the market is down 30% with my dividend strategy because I’m not forced to sell anything; I’m still going to receive my dividends, which is going to keep my cash flow the same, but let’s take a closer look during the last meaningful Market correction which took place in 2020:
- U.S. Companies cut dividends by 22%
- Emerging Markets cut dividends by 29%
- All other countries cut dividends by 41$
Source: Dividends in the Time of COVID-19
When you add all these up, that’s significantly less money coming in compared to before. When companies face financial struggles, dividends are often among the first expenses to be slashed to preserve cash flow.
Misconception #3: The Tax Implications
Taxes can also complicate the dividend strategy, especially in non-registered accounts. For example:
- If you receive $20,000 in eligible dividends, you’ll need to gross it up by 38% and report $27,600 as income.
- This can push you into a higher tax bracket, potentially triggering a clawback of government benefits like Old Age Security (OAS).
In comparison, if you generate $20,000 from selling shares at a capital gain, only 50% of the gain is taxable. This often results in a smaller tax bill and less impact on your government benefits.
Misconception #4: Dividend Stocks Provide Diversification
Back in 1927, 68% of US companies paid dividends, and that number today has dropped down to 38%. By only focusing on dividend-paying stocks, great companies are being left out of the portfolio. In the US, for example, you’d be missing out on Amazon, Tesla and Birkshire Hathway.
Back to taxes quickly
Just going back to taxation for a moment dividends received from foreign companies are not going to be taxed as favorably in Canada. If you want the most tax-efficient dividend-paying stocks, you’re stuck to buying Canadian companies. That’s because Canadian corporations can pay out what’s called eligible dividends. Depending on what province you’re in, they can be taxed quite favorably; however eligible dividends can come with their own set of problems.
The Bottom Line
So, should you avoid dividends altogether? Not at all. Dividends can play an important role in a diversified retirement strategy. The key is to avoid relying solely on them for income. Instead:
- Focus on Total Return: Consider the combined impact of growth, dividends, and interest.
- Incorporate Tax-Efficient Withdrawals: Blend withdrawals from registered accounts, taxable accounts, and capital gains to minimize taxes and maximize after-tax income.
- Diversify: Include a mix of stocks, bonds, and other asset classes.
Living off dividends may sound appealing, but it’s not the guaranteed, risk-free strategy many believe it to be. By understanding the limitations and adopting a more balanced approach, you can build a sustainable retirement income plan that minimizes risk, maximizes tax efficiency, and helps you achieve your retirement goals.
Watch Video: How Dividends Affect an RRSP Meltdown
