“Hello everyone! Today I have a guest post from Joe, a personal finance blogger who founded Average Joe Finance to help spread easy to understand financial education. Let me know if you would like to guest post on Finance For Geek.” – Vincent
Dividends vs. Interest
When it comes to retirement, the key is looking for a steady, relatively safe income stream. This is why many people often choose bonds as their main investment. However, many people often feel that dividend paying stocks offer a great alternative. So, is one really better than the other? Well it depends on your objectives and risk tolerance. Both bonds and dividend paying stocks have pros and cons for retirement investors.
First off, dividends and bonds have different tax implications. Assuming that your dividends are qualified, you will pay anywhere between 0% and 20% in federal income tax, plus any applicable state and local taxes. If you’re in the lowest two tax brackets, you won’t pay any taxes, while those in the highest tax bracket pay 20%. Everyone else is taxed at 15%.
Interest from bonds are taxed differently depending on the bond type.
US Government securities (like Treasury notes and bonds) are only taxable at the federal level, however they are taxed at your normal income tax rate.
Municipal Bonds are free from federal, state and local tax if you live in the same state or municipality as the issuer, if not you will be subject to tax at your normal income tax rate.
Corporate bonds are always taxed at your normal income tax rate for federal, state and local taxes. If you were to sell any of the bonds on a secondary market before their maturity, you would be subject to capital gains tax just as you would if you bought and sold a stock.
Both bonds and dividend stocks carry risks. While everyone knows that stock prices can fall, the price of bonds can rise and fall as well. Since bonds are long-term investments, their price is linked to current interest rates. A bond paying 5% interest when interest rates were around 5% will not be worth as much if interest rates moved to 6%. This is because an investor can get a better return (6% vs. 5%) on a newer bond.
As a result, the price of the bond falls to the point where it’s effective interest rate is around 6% or higher. Conversely, if interest prices fall, the bond becomes worth more and its price will rise. Since most bonds pay a set interest amount the price has to adjust in order to raise or lower the effective or current interest.
To clarify this point let’s look at an example. When you purchased the 5% bond it cost $1,000 and was paying $50 interest per year. Since the $50 interest says the same, in order to get the interest rate up to 6%, the price has to drop to $833 ($50/$833 = 6%).
If you’re planning on holding the bond until maturity, then short-term fluctuations aren’t a major concern. However, if you’re investing in riskier bonds (those not backed by the government) then you do run the risk of default. If a company or municipality declares bankruptcy, it is a very real possibility that interest payments will stop and that they won’t have enough money to pay back your entire initial investment.
In addition to price risk for dividend stocks, investors run the risk that the company has to cut the dividend payout. While interest payments on bonds are fixed, companies can raise or lower their dividend at any time. During the most recent recession, many cash-strapped companies drastically lowered or completely eliminated their dividend. If you find a stock paying an above average dividend, double check to make sure the dividend payout is sustainable and won’t be cut.
Based on your investing outlook, both bonds and dividend stock offer some advantages. As I mentioned earlier, except for bankruptcy situations, bonds pay back your initial purchase price (assuming you buy a new issue) at the end of their term. This provides a major advantage over stocks in which the return of your initial investment is never guaranteed. Bonds also offer set interest payments, that can help with cash flow planning during retirement.
Dividend stocks have the advantage of being more liquid than bonds. Since stocks are actively traded, they are much easier to buy and sell. Also, stocks are cheaper than bonds (which typically come in $1,000 increments). This helps with diversification, since you can buy a variety of different stocks for the price of one bond. This helps to spread out your risk across multiple companies instead of having one bond. To mitigate this issue with bonds, you could purchase a bond fund to help diversify.
Evaluate Your Situation
So, are dividend stocks better than bonds for retirement? Like most things dealing with personal finance, it really depends on your current situation. If you’re in a high tax bracket and are able to invest in tax free municipal bonds, then bonds would be the way to go. If you’re open to more risk and in one of the lowest tax brackets, receiving tax free dividends would be my preferred choice.