Do Low Dividend Stocks Belong In A Roth IRA?

by: Tim McAleenan Jr.

The wisdom of holding a high dividend stock within the tax-protected confines of a Roth IRA is pretty self-evident because you are protecting the total returns of a cash-generating asset from the taxman by not exposing yourself to the dividend tax. For instance, a $10,000 investment in BP (NYSE:BP) over the past twenty years has paid out a total of $30,063 in cash dividends to its owners.

With a payout like that, it makes strategic sense to protect that income from the 15% (or more) annual tax bites that would nibble at your gains with each passing year. The appeal of keeping your cash cows like oil giants, tobacco companies, and telecom firms inside of a tax-protected structure is that a lot of the total return consists of the dividends, and you wouldn't want to see that portion of your total return claimed by the government.

A more interesting dilemma is trying to figure out whether companies with low dividend yields, perhaps in the range of 1% or 2%, are worthy of consideration for your IRA. The easy kneejerk response is to say "no they don't." The reason why companies like IBM (NYSE:IBM) may appear suboptimal in something like a Roth IRA is because most of the company's profits are naturally shielded from taxation; in the case of IBM, the company generates $14.47 per share in profits while only paying out $3.80 to shareholders as a dividend.

About 75% of IBM's earnings per share are retained by management to grow, buy back stock, and pay down debt. If you own IBM in a taxable account, the fact that IBM pays such a low initial dividend makes it seem almost inconsequential to care about whether it belongs inside of something like a Roth IRA because most of the profits are shielded from taxation that you directly pay due to the nature of companies with low starting dividend yields that buy back large amounts of stock on behalf of owners.

If your investing horizon is short to medium term (say, three to five years or so), then the conventional wisdom on optimal asset allocation could be worth following: low dividend stocks belong in taxable accounts, and Roth IRAs are for cash cow common stocks, high-yielding corporate bonds, and so on.

But, if you are someone with a longer time horizon (10-25 years), then those low dividend stocks with a high dividend growth rate probably don't deserve to be ignored within the context of Roth IRA investing. Sticking with our IBM example, take a look at what the company has turned a $25,000 investment into over the past twenty years: 2,228 shares paying out $8,466 in annual dividends worth a little over $400,000. For the truly patient investor, that block of IBM stock is now paying you 33% of your initial investment in cold, hard cash profits.

And also worth mentioning is the $375,000 gain that IBM investors would be sitting on. The presence of the huge capital gains that a "low starting yield + high dividend growth rate" investment can give permits you to have many options inside of your IRA. Because of the enormous tax benefits conferred upon a retirement structure like a Roth IRA, you have to deal with contribution limits (it varies by age and income, but is now $5,500-$6,500 for most eligible contributors). It would take 72 years of cash deposits at a $5,500 rate to get a Roth IRA account to the $400,000 level, and that is why it could be useful to have those high earnings per share growth investments inside of a Roth IRA so that you could ultimately increase the amount of total assets that you have shielded within the Roth IRA structure.

Holding the low yielders with high growth rates for long periods of time can give you options. With that $400,000 in IBM stock, you could convert it to a collection of oil giants, tobacco companies, REITs, and telecom companies that give you $20,000 in tax-free retirement income from the share of those profits alone. Or, you could stick with the IBM stock: annual dividend growth of 8% here, 12% there might be something worth keeping safely tucked away in your portfolio.

On the verge of making withdrawals, using your tax shelters like a Roth IRA for the low-yielding, high dividend-growth-rate investments may be a suboptimal use of the tax protections afforded to tax-deferred vehicles. But, if you open up your time horizon a bit and look ten years down the road, then there may be a spot for the Disneys (NYSE:DIS), Becton Dickinsons (NYSE:BDX), and IBMs of the world within a Roth IRA for two reasons: the initial investment amount may actually be generating decent investment income worth protecting come 2025-2030, and the huge capital gains that accompany the high dividend growth rates creates an opportunity for you to convert those capital gains into higher-yielding investments down the road, maximizing the income generated by your Roth IRA in the long run.

Disclosure: I am long BP, . I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.