5 Hidden Dangers of Dividend Stocks You MUST Know!

Not all dividends are as sweet as they seem. Just like in fairy tales, some stocks disguise themselves as safe, reliable income sources while secretly waiting to take a bite out of your portfolio. Welcome to the Simply Safe Dividends channel, I'm your host Brian Bollinger, and in this video I'm exposing five hidden dangers of dividend stocks that you should know not only to avoid dividend cuts, but to save on taxes, make better buy and sell decisions, and ultimately protect the long-term worth of your income portfolio, especially if you're in or near retirement. I've been investing for nearly 20 years and have made more than my fair share of mistakes along the way, so I'm hoping this video will help you avoid some of the traps, both common and not so common, that can catch dividend investors off guard. The first hidden danger might seem a little obvious, but dividends are tied to the economy. When times are good, more companies have extra cash they can return to shareholders in the form of a dividend, but when recessions hit, the opposite is also true as businesses hunker down and care more about preserving their cash. You can see this relationship play out pretty clearly in this chart, which goes back 75 years and plots dividends paid by S&P 500 companies in green, with recessions marked by the grey bars. Most of the time the economy is growing and corporate profits are rising, which has supported around 6-7% annual dividend growth over the long run. However, recessions can cause dividends to decline or put up weak growth for years at a time. The pandemic in 2020 caused S&P 500 dividends to dip by only about 3% before quickly rebounding, but you can see that the 2008 financial crisis was much more severe, with a nearly 25% decline in payouts that took almost 5 years to fully recover from. Dividends have fortunately been fairly resilient or even increased in other recessions dating back to 1950, but the bottom line is that if you are investing in dividend stocks for income, you really need to have a recession mindset and own a portfolio of companies that you believe can ride out the next downturn with their payouts intact. The good news is that this is very possible to do. At Simply Save Dividends, we spend a lot of our time maintaining dividend safety scores on over 1,000 stocks and closed-end funds. Our scores gauge dividend risk over a full economic cycle to account for a recession occurring at some point in the future, and they're backed by a public real-time track record I'll link to below in the description. Investors who stuck with companies that maintained a safe or very safe dividend safety score would have avoided at least 97% of the more than 850 dividend cuts we've seen since we started doing this in 2015. Recessions aren't the only challenge for dividend stocks, though. Interest rates can be a big factor as well, since many popular high-dividend stocks like REITs and utilities will compete with bonds for investor money. When the Fed raises interest rates or investors worry more about inflation, bond yields go up and represent a safer, better-paying option, so some investors will ditch their dividend stocks and move their cash into bonds. All else equal, this causes dividend stock prices to fall and their dividend yields to rise. Realty income, ticker symbol O, provides a nice example of this dynamic. Realty is a large-cap retail REIT that's paid safe dividends for over 50 years, so it's been a very reliable high-yield stock, but with slow dividend growth that has averaged only about 3% per year in recent periods of time. This chart I put together goes all the way back to the year 2000 and plots Realty's dividend yield in dark blue, alongside the yield offered by 10-year Treasury bonds in orange. You can see that Realty income's dividend yield has historically moved in the same direction with these government bond yields during most periods of time outside of recessions, and it has sat about 2-3% higher since stocks are riskier than Treasuries and investors demand some higher return to hold them. Bond yields bottomed out at about 0.5% in 2020 and are about 4.6% today, which pushed Realty's dividend yield up from below 4% to almost 6% during that same period and caused the stock to underperform the S&P 500. Hopefully bond yields stabilize from here, but your guess is as good as mine. To give you a feel for what could happen if rates shoot higher again, Realty income's dividend yield was 10% in the early 2000s when the 10-year Treasury yield topped 6%. To get back to that dividend yield level, the REIT's share price would need to drop over 40% from its current level. My main point here is to be mindful of the impact bond yields have on the valuations of many dividend stocks in high-yield, slow-growth areas like REITs, utilities, consumer staples, MLPs, and BDCs. I know it can be tempting to load up on these types of stocks for income, but doing so requires a tolerance for unpredictable shifts in interest rates that can significantly impact the valuations of even the best businesses for better or worse. I like to keep a diversified mix of dividend growth stocks in my portfolio that can help smooth out some of this REIT volatility. A lot of bond-like stocks like Realty Income fall into the high-yield category, which is the third potential danger of dividend stocks I want to discuss. You don't have to look far to find articles or even paid newsletters pushing stocks with double-digit yields or portfolios that can yield 8% plus. Income sizzles is what sells, I get it. After all, the higher the yield your portfolio can deliver, the sooner you can retire, in theory. For example, if you needed $100,000 of income, a 4% yield would require a $2.5 million portfolio, but a 10% yield would let you hit your income goal with just $1 million instead. Unfortunately, trying to achieve much more than a 4% to 5% yield comes with major sacrifices across dividend safety, portfolio diversification, and long-term growth. To show you what I mean, I'll hop over to our website, SimpliSafe Dividends, and we'll do some yield hunting together. After logging into our website, I'll navigate over to our screener for companies, and I will search for stocks that have a dividend yield of at least 5% and a dividend safety score of borderline safe, safe, or very safe, which will weed out a lot of the more speculative junk from this high-yield group. That cuts the number of stocks in half to just over 100 matches, and I did the same thing on the closed-end fund side, 36 funds with a yield of at least 5% and a borderline safe and up dividend safety score. I threw all those things together into this high-yield portfolio worth $1 million. I equal-weighted the portfolio as well, so you can see each of these holdings is about 0.7% of the portfolio, and that ends up giving you almost a 7% yield, so $68,500 of annual dividend income with this portfolio we put together. But that's about where the good news kind of ends if you're a conservative income investor. If we go over to the diversification report, we can see that on the plus side, our income stream is very well diversified. These two PIMCO closed-end funds each account for about 1.2% of our annual dividends, so we're not betting the house on any certain high-yield stock that could head south. That is a positive, but this portfolio is very concentrated in real estate, energy, and financials. These three sectors account for about 60% of its value. Real estate side, it's going to be lots of different REITs, office and industrial, everything from healthcare and retail. If you look at the energy space, you're seeing a mix of MLPs as well as oil and gas producers like BP are in here. And the financials side is going to consist of a lot of business development companies as well as both regional and community banks. Now these three groups, what do they have in common? They all tend to get hit pretty hard during recessions because they could be capital-intensive businesses like a lot of energy firms and REITs that depend heavily on debt financing. That can become a little bit dicier when the tide goes out. In the financials space, you also have these banks and BDCs that see rising credit losses in their loan books. So there's a lot to kind of worry about, lower oil and gas prices as well, a lot to worry about with over half of your portfolio. That kind of makes me uncomfortable as a conservative investor. Meanwhile, you see kind of defensive areas like utilities and staples are pretty underrepresented at less than 20% of the portfolio's value. And some of the great areas for dividend growth stocks like industrials are hardly there at all, 4% weight. So this portfolio makes me a little bit uncomfortable with what could happen in the next recession because it consists of mostly businesses that struggle during those hard times. And we can see that reflected in the dividend safety report. So 85% of the income this portfolio is generating is coming from companies with a borderline safe rating. The good news is we expect at least two thirds of companies with a borderline safe score to maintain their dividends over a full cycle. But many of these companies have somewhat higher payout ratios, higher leverage, cyclical earning streams, factors that just give them a lower margin of safety to weather a downturn. So you're going to be feeling a little stress for sure whenever the next recession hits with this type of weighting. As a conservative investor, I'd rather see these numbers flipped. I don't mind having some borderline safe in my portfolio, but I'd rather see kind of 85% plus of my income coming from stocks with safe and very safe ratings. But the biggest factor over the long run to really think about is the lack of growth. So usually when you reach for yield, you're seeing weaker and weaker dividend growth the higher up you reach for that yield. And this has been true here. So this portfolio over the last decade would have generated about two, maybe 3% annual dividend growth. That's ignoring reinvestments. We're not putting in more money to the portfolio. That's just the underlying growth rate of these holdings. And that's pretty weak. I mean, that's below today's rate of inflation, which who knows where that will be over the next decade. But I think you're going to really struggle to maintain your purchasing power with that type of growth and the potential for a recession to kind of rock the annual income. And to show you one more example of why that's important, I put together this simple two-stock portfolio, Pepsi and Verizon. I said, hey, what if we bought these 10 years ago, $1,000 in each, roughly. So Pepsi 10 years ago was $99, Verizon was $49 a share. And to show you the power of faster growing dividends, take a look at this. So when we first bought in, again, $1,000 of each, Pepsi had a much lower yield. So we were only getting $24 in that first year of dividends compared to Verizon's 42, which is almost double Pepsi's dividend. Now over the next decade, Verizon's dividend only grew about 2% a year. Pepsi's grew at more of a high single digit type of rate and closed the gap entirely. So last year, $52 in dividends from Pepsi, 53 from Verizon, and Pepsi will deliver more income for us this year than Verizon, even though it started out as such a smaller dividend payer. And that's really the power of compounding. If you add this up over 10, 15, 20 years, those stocks that might only yield 2, 3% today, but are growing those dividends at 7, 8, 9, 10% a year can actually result in a bigger, faster growing income snowball when you get out 10, 15 years from now. So that's something really important to keep in mind is that that high yield opportunity cost is very real and the companies that have kind of lower yields, but better dividend growth are also going to be more likely to generate nice capital appreciation that gives you more flexibility with your portfolio too. Whether you're a high yield investor or you prioritize faster dividend growth, you can save a lot of money and headaches with a basic understanding of how different types of dividends are taxed, which represents our fourth hidden danger of dividend stocks. So this table itself looks kind of dangerous, but it's showing you different types of dividend sources, everything from corporations to funds and preferred stock, how those dividends are taxed and the best type of account typically to hold those types of dividend payers in. I'm not going to go into all the weeds here. You're welcome to kind of pause the video for a closer look if you like, but I'll try and touch on the high level points that are most helpful. So most of the dividends you're going to encounter are likely what's known as qualified dividends from corporations like McDonald's, Coca-Cola, Nike. These are taxed at the long-term capital gains rate of zero, 15 or 20 percent. If you're in a low income tax bracket, it can actually be quite advantageous to hold these dividend payers in a taxable brokerage account. I'll talk more about that in a couple minutes, but there's other types of companies out there as well. Like REITs and BDCs mostly pay what's known as non-qualified dividends. So these companies are passed through businesses. They don't pay tax themselves. They pass that obligation on to their shareholders, us. So when you receive dividends from these types of companies, you will pay taxes on them at an ordinary income tax rate up to 37 percent. So because of that higher tax rate, it usually makes more sense to hold these companies in a tax-advantaged account like an IRA to defer those taxes or in the case of a Roth, never have to pay the tax on those dividends. MLPs are kind of their own unique breed. Their distributions are mostly what's known as a return of capital, which defers your taxes. This lowers your cost basis in the stock and then whenever you sell it, however much that cost basis came down, you're going to pay capital gains on that difference. These also issue a K-1 tax form. You should hold MLPs typically in a taxable account. There are some exceptions, but usually a taxable account for, again, some reasons I won't get into, but that's one big difference compared to the other pass-throughs, BDCs and REITs. On the fund side, whatever the holdings do, however their dividends are taxed, is usually the treatment that will be passed along to the investors in the fund. So if an ETF owns kind of a mix of REITs and corporations, you'll probably receive dividends that are taxed both as qualified and non-qualified dividends. Foreign stocks is the last thing I'll highlight from this table. So if you're investing in companies that are headquartered outside of the U.S., chances are that country has a foreign dividend withholding tax that gets applied. So instead of sending you the full dividend payment that you see, you might only get 70% of it. It really depends. The U.S. does have tax treaties with most countries that reduces that rate, usually to 15% or so, and you can also claim a foreign tax credit. But that's something to be aware of if you're looking at international companies that are based outside of the U.S. Usually it makes more sense to hold those in taxable accounts, except for Canadian stocks, which are safe to hold in IRAs. Now how do you keep track of all this stuff? On our site, every company will show you a dividend taxation box here, which tells you what type of dividend the company pays. In the case of Realty Income, this is a REIT, so it pays a non-qualified dividend. And we'll let you know if it issues a Form 1099 or a K-1 in the case of MLPs like EPD. Like I said earlier, Coke and McDonald's, you'll see these are qualified payers with a Form 1099, pretty straightforward. You can also view this information in your portfolio. There's a dividend taxation column you can add to even sort by the different types of payers you might have. You'll see Canadian stocks here, K-1, foreign. And on our screen here, the last thing I'll show you, you can also look at stocks. You can screen out certain types. So maybe you only want qualified dividends. You can look for only stocks that pay a qualified dividend, which is over 600. So very easy to kind of navigate this otherwise kind of confusing topic of dividend taxes. But what about the dividend critics who say, you know, there's a big tax drag caused by this strategy. If you're holding a dividend payer in a taxable account, you're going to lose part of that payment before you can even reinvest it. And that's going to kind of drag down your portfolio's long-term compounding potential. Now there's certainly some truth to that, but there's also an ability for a lot of folks to avoid most, if not all, of the taxes on their dividends. So the table you're looking at here is showing you the tax rates for long-term capital gains and qualified dividends. And if you are married, you can see that you will not owe any federal tax on your dividends if your income is under $96,700. And that's taxable income. So that's after this $30,000 standard deduction you get. In other words, you could have total income of almost $130,000 of qualified dividends and not pay a penny in federal income tax on those dividends. Now, that amount will kind of come down if you have other income sources, maybe from a business or from wages. But in retirement, this can be a great benefit, especially if you can kind of pair it up with some of those tax-advantaged accounts like a Roth to generate a nice healthy income stream. So there's a lot to the topic of taxes, but just understand that there's different tools you can pull with where you hold certain types of companies or the companies you invest in and the funds to try and minimize that obligation and maximize your portfolio's after-tax yield, really holding on to every hard-earned dollar that you can. This final dividend stock danger is a nod to a 1979 hit by the late Tom Petty about a fleeting young romance, one that only happened because, as the song says, even the losers get lucky sometimes. I've invested in plenty of losing stocks over the years, including some that have cut their dividends and it's hard to let go. You really want to believe that the company will recover or stumble into some luck that allows you to break even, and realizing a loss feels like admitting failure. Sometimes a company that cuts its dividend will still have a reasonably attractive yield, which only adds to that urge to hold on to a loser. A very common question I get is when to sell a stock, especially one that has fallen on hard times. My short answer is, it's usually a bad idea to hold on to a dividend cutter. Yes, there can be some exceptions like we saw during the pandemic, but in most cases when I look at all the dividend cuts we've seen over the last decade, losers kept on losing. If I had to guess, and this is purely anecdotal, I would say that companies that cut their dividends and find themselves in turnaround mode end up being great long-term investments less than a third of the time, and you need a lot of patience and a stomach for high volatility throughout most of those journeys if you choose to go on them. Data from Hartford Funds shows a similar conclusion. They broke out stocks in the S&P 500 by dividend policy and reviewed their returns over the last 50 years. Dividend cutters had by far the worst returns and the highest standard deviation or volatility over that period. You can really see these figures come to life when they are charted with a starting value of $100 in 1973. The black line at the bottom shows the group of dividend cutters and eliminators fell to $73 over that time versus a worth of more than $14,000 for healthy companies that initiated and grew their dividends. When you're holding a dividend loser, it can be helpful to ask yourself if you would really buy the stock again today if you didn't already own it. I know these aren't easy calls to make, but the data backs the idea of moving on from your losers with the dividend cut being the most obvious sign that something has likely changed with the company's long-term outlook and there are probably better opportunities elsewhere. I know this was a lot of information to take in, so thank you for watching if you made it this far. I hope you picked up a few helpful tips for your portfolio, and if you're interested in seeing how safe your income looks and finding some actionable dividend ideas, you're more than welcome to try out our website, Simply Safe Dividends, for free using the link in the description below. Thanks again for watching and I hope to catch you next time.