It’s easy to see why dividend stocks might appeal to investors. After all, who wouldn’t want the chance to sit back, do nothing and enjoy a steady stream of payments?
But while dividend-paying stocks can be a good way to passive income, they’re not automatically a great investment. Here’s why it pays to be careful with dividend-paying stocks — or perhaps avoid them altogether.
1. They may not match your investment strategy
Companies that pay dividends to shareholders make the decision to split their profits rather than investing more money in the business. And that’s not necessarily a good thing. By giving away that money instead of reinvesting it, companies that pay dividends could stunt their own growth. And that could lead to slower stock price appreciation.
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If your investment strategy is centered on filling your portfolio with growth stocks, dividend stocks may not be suitable. And there’s no sense deviating from your strategy if it has served you well so far.
2. They can increase your tax bill
If you hold dividend stocks in a tax-advantaged retirement plan like a 401(k) or an IRA, the dividend income you receive on an ongoing basis will not be taxable on an annual basis. But if you hold dividend-paying stocks in a brokerage account, those payments could result in a higher tax bill for you.
Granted, dividends (at least qualified) are taxed at a more favorable rate than ordinary income, so the impact may not be as severe. But at the end of the day, taxes are taxes, and if you don’t want to pay the IRS more on an annual basis, you might want to pass on the dividend stocks.
3. They can cause you to make bad investment choices
It’s easy to be seduced by the lure of a generous dividend. But it might tempt you to invest your money in companies that aren’t really strong.
It’s a big misconception that companies that pay big dividends can afford to do so, and so it’s clear they’re doing well. That’s like saying the guy in your neighborhood who drives a $90,000 sports car needs to be charged because he can rock those vehicle payments. In reality, this guy may be drowning in debt or having $0 in savings, and all his fancy car is doing is masking that reality.
The same may be true in the context of dividend stocks. Companies that pay big dividends aren’t necessarily doing well financially. And if you don’t make that distinction, you could find yourself really unhappy with the stocks you’re investing in.
Watch out for dividend stocks
Dividend stocks could be a great investment, one that helps you achieve your financial goals. But the fixation on dividend-paying stocks could also backfire. And it’s important to be aware of this fact before you go in search of dividends, while passing up the opportunity to invest your money in quality businesses that are more likely to reward you in the long run.
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