5 Tips for Using Dividend Stocks to Pay for Retirement

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ShutterstockDividend stocks are more stable than other types of equities, but have more risks than bonds.

By David Ning

With many savings accounts paying less than 1 percent interest, some retirement savers are turning to dividend stocks to provide a more reasonable return. Dividend stocks provide a stream of income as well as the potential for capital gains, but they also carry more risk than a savings account, certificate of deposit or bonds. Here's what you should know about using dividend stocks to pay for retirement.

Dividends can stop at any time. Dividends are distributions of company profits to shareholders. Using the income derived from dividend paying stocks to fund retirement is a viable strategy for many people. However, if profits decline, your dividend might also decrease or even be eliminated. You have to be prepared for the possibility of a surprise dividend cut in the future. If the companies you choose have a bad year, your retirement income might suffer as well. Of course, the reverse could also be true. A company that performs well might provide an increase in dividend payments.

Diversification difficulties. Companies that pay significant dividends are concentrated in a few industries. Investing exclusively in dividend stocks isn't likely to provide adequate diversification of your investments. It's difficult to make a diversified portfolio of stocks that currently sports a high yield and has the ability to grow its dividend for the foreseeable future. You may have to spend time researching and monitoring these stocks during your retirement years.

%VIRTUAL-WSSCourseInline-908%Less volatility. Dividends are less volatile than stock valuations. Dividend stocks tend not to increase as quickly as the market as a whole, but they also tend to hold their value a little better when the market goes down. However, dividend stocks are not a risk-free investment, and carry more risk than high-quality bonds. The business landscape is always changing. Investing in a single stock always carries the risk of something going wrong at that company. A stock that does extremely well for decades could suddenly start declining because innovations are disrupting that industry. You may be able to mitigate some of the risks by building a diversified portfolio with many stocks or investing in high-dividend mutual funds or ETFs instead of picking stocks on your own.

Tax efficiency. Dividends are typically taxed at a lower rate than bonds or other ordinary income, which makes dividend stocks a tax-efficient source of retirement income. However, when you sell the investment you may also owe capital gain taxes. If you are forced to sell all of your stock in a company years from now at a tremendous gain because the prospects are no longer bright for that company, it could result in a large tax bill. Selling only a portion of your investments every year, and spreading out the capital taxes to be paid in multiple years and possibly within a lower tax braket, could result in a smaller overall tax bill.

Spending only income will result in money for heirs. If you spend only the dividends your investments generate, you will almost certainly leave money behind for heirs. This may be desirable to parents who want to pass on wealth to their children, but it also means that you aren't spending as much as you could in retirement.

David Ning is the founder of MoneyNing.com.

Originally published