Dividend Income Investments: Benefits and Pitfalls

Dividend Income Investments: Benefits and Pitfalls

In this issue:

• Latest in Retirement Savings & Personal Finance
• Dividend Income Investments: Benefits and Pitfalls
• Dividend Income Calculator for Stocks, ETFs, and Mutual Funds
• Market Overview

Latest in Retirement Savings & Personal Finance

Here is some of the latest news:

Higher Default 401(k) and 403(b) Savings Rate

The SECURE 2.0 Act, enacted on December 29, 2022, mandates that starting in 2025, most newly established 401(k) and 403(b) plans must automatically enroll eligible employees at an initial contribution rate of at least 3% of their compensation. This rate is required to increase automatically by 1% annually until it reaches a minimum of 10%, but not exceeding 15%, of the employee’s compensation. However, this requirement does not apply to plans established before December 29, 2022.

As previously mentioned, we recommend that workers aim to save at least 6%, or ideally 10%, as a default contribution rate or as a rule of thumb. Nonetheless, starting at a 3% contribution rate at least something. This is particularly important for generations without access to defined benefit plans or pensions in retirement.

Rising Healthcare Cost in Retirement

Fidelity projects that a 65-year-old retiring today could spend $165,000 on health care in retirement, or more than $300,000 for a married couple. This estimate does not even include other health-related expenses, such as over-the-counter medications, most dental services, and long-term care. The long-term care cost is expected to be $116,000. Consequently, it would be roughly close to half a million dollars for a married couple to cope with health care and long-term care costs during retirement, a tall order.

Uncle Sam Wants Your Tax Immediately

Starting in 2026, workers age 50 and older who earned $145,000 or more in the previous year will be required to funnel catch-up contributions to a Roth 401(k) plan. This is because the government wants to collect your tax immediately!

Dividend Income Investments and Beware of Their Pitfalls

Dividend income is popular for many to generate passive income, especially during retirement. However, not all dividend income is created equal. Depending on the type of investment, dividends can have varying levels of risk, tax implications, and sustainability. Below we explore the different types of dividend income and point out potential pitfalls to watch out for.

Dividend Income from Regular Stock ETFs, Mutual Funds, or Individual Stocks

This category includes investments like the Vanguard Dividend Appreciation ETF (VIG), which focuses on companies with a history of growing dividends. They are just regular (blue chip) companies that are paying dividends. These are ideal for investors seeking stability and gradual income growth. A regular dividend stock fund such as VIG also provides diversification. 

Pros:

• Stability: Funds like VIG focus on high-quality companies with consistent dividend payouts.
• Tax Benefits: Qualified dividends are often taxed at lower rates compared to regular income.
• Diversification: ETFs and mutual funds provide exposure to a basket of dividend-paying stocks.

Pitfalls:

• Lower Yields: These funds prioritize growth over yield, meaning the dividend income may be lower than other investment types. Typically range from 2% to 4%. For example, right now, VIG is paying 1.96% dividend annually
• Market Risk: as always, keep in mind that these are stock funds, and they remain susceptible to significant volatility or drawdowns.

High-Income Master Limited Partnerships (MLPs) and Similar Investments

MLPs, along with certain real estate investment trusts (REITs) and other high-income investments, often pay out attractive dividends. However, these distributions can be more complex. For those unfamiliar with MLPs, Master Limited Partnerships (MLPs) are publicly traded entities that focus on energy infrastructure, such as pipelines, storage facilities, and natural gas processing plants. An example of MLP ETFs is Alerian MLP ETF (AMLP) that has holdings like Planis All American Pipeline (PAA) or Energy Transfer LP (ET) etc. 

Pros:

• High Yields: MLPs typically offer higher payouts compared to regular stocks. For example, AMLP yields 8.5% right now. 
• Exposure to Specialized Sectors: Many MLPs operate in energy or infrastructure, providing diversification.

Pitfalls:

• Tax Complexity: MLP dividends are treated as regular income for tax purposes and require special forms, such as Schedule K-1. This can complicate tax filings.
• Sector Risk: MLPs are often concentrated in specific sectors like energy, which are subject to cyclical risks.
• Potential Tax Inefficiency: MLPs are not always suitable for tax-advantaged accounts like IRAs, as their income may trigger unrelated business taxable income (UBTI).

High Dividends/Distributions from Closed-End Funds (CEFs)

Closed-end funds like Cohen & Steers Quality Income Realty Fund (RQI) and Pimco Dynamic Income Funds (PDI) often offer enticingly high yields. These funds combine traditional dividends with other income sources. They are popular among retirees who are looking for high income.

Pros:

• Attractive Yields: CEFs can provide higher distributions than traditional ETFs. Currently, RQI yields 8.18%. 
• Access to Specialized Strategies: CEFs often invest in niche areas or use leverage to boost returns.

Pitfalls:

• Return of Capital (ROC): A portion of the income may come from return of capital, which is essentially a return of your own invested money rather than actual earnings. This is NOT a real income!
• Leverage Risks: Many CEFs use leverage to enhance income, which can amplify losses in down markets.
• Complexity: Understanding what portion of the payout is actual income versus ROC requires careful review of fund disclosures.

Option-Driven Income Funds

Funds like YieldMax ETFs or MSTY (YieldMax MSTR (Microstrategy) Option Income Strategy ETF) generate extremely high income through complex options strategies rather than traditional dividends. These funds often target single stocks, using options to generate high income.

Pros:

• High Income Potential: These funds often boast eye-catching yields, which can appeal to income-focused investors. Currently, MSTY yields a whopping 140%!
• Innovative Strategies: They offer exposure to unique income-generation methods that differ from traditional dividends.

Pitfalls:

• Higher Risk: These funds are tied to the performance of single stocks, like MSTR in the case of MSTY. Poor stock performance or volatility can significantly impact returns.
• Total Return Concerns: While the yields might appear high, total returns often underperform over time due to the fund’s inherent risks and the drag from option premiums.
• Tax Implications: Option income may not qualify for favorable tax treatment, and the short-term nature of the income can result in higher taxes.

The examples above highlight just a few popular types of income investments. Each type warrants a more in-depth discussion to fully understand its nuances, benefits, and risks. These topics will be explored in greater detail in future newsletters and articles.

Total Return Approach

We have always advocated a total return approach. A total return is essentially when your investment (such as VIG) has dividends reinvested, and its performance is calculated based on price appreciation plus the compounded effect of dividend reinvestment over time. A total return-focused investor would designate their investments to reinvest dividends and then sell off shares as needed to generate income. Below are some comparisons of total returns among similar investments:

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TSLY has performed significantly worse in 2024 compared to TSLA. Investors who invest in TSLY for income would likely receive significantly lower returns, and thus less income if shares are sold. On the other hand, RQI, the CEF, has performed better than VNQ, the REIT index ETF. However, RQI also comes with much higher volatility, just beware.

Tools & Tips: Dividend Income Calculator for Stocks, ETFs, and Mutual Funds

The Dividend Calculator for Stocks, ETFs, and Mutual Funds estimates potential dividend income over time. Whether you’re investing in dividend-paying stocks, exchange-traded funds (ETFs), or mutual funds, this calculator provides valuable insights by allowing you to input your investment amount or number of shares and past time-period. It calculates the total dividends accrued and provides an annualized dividend yield,

You can enter a symbol like VIG, JNJ, RQI, or PTTAX, or even a partial name like “PIMCO Total Return.” The tool will automatically calculate the total dividend income accrued and the annualized dividend yield for the selected period, such as the past 10 years, based on the amount you invested at the beginning of the period. You also have the option to specify a custom period by providing a start and end date. Additionally, you can choose to input the number of shares instead of the investment amount.

This calculator is also embedded on stock or fund quote pages, such as VIG.

Market Overview

Last week, the new administration was sworn in, and investors are generally optimistic about the economic and market-friendly policies of the new administration.

Furthermore, major banks have begun reporting their earnings for the fourth quarter of last year:

• JPMorgan Chase reported a 50% surge in net earnings, exceeding $14 billion in the fourth quarter of 20244.
• Wells Fargo reported a nearly 50% increase in net income to $5.1 billion for the fourth quarter.
• Investment banking revenue soared, with JPMorgan and Bank of America reporting increases of 49% and 44%, respectively.

As a result, the SPDR S&P Bank ETF gained more than 8% in the week following the earnings announcements. 

The following table shows the major asset price returns, as of last Friday: 

Struggling to Select Investments for Your 401(k), IRA, or Brokerage Accounts?