Savings Switch: Interest Savings vs. Dividend Stocks

NEW YORK (MainStreet) — A year or two ago, almost no one would have predicted that interest rates would still be at rock-bottom levels halfway through 2011. But they are, driving many investors to take on bigger risks reaching for higher yields.

Just consider this suggestion from a recent story in The Wall Street Journal:

“There isn't much yield in Treasuries. Cash isn't paying anything. And municipal bonds face uncertainty as governments work feverishly to get budgets back in order with varying degrees of success.

“That means, paradoxically, that the stock market is the best place for yield hunters right now. And thankfully, there isn't any shortage of blue chip stocks sporting strong dividend yields.”

Is it really that simple? Not exactly. Savers risk real trouble when they think shifting money from bank savings to stocks is like moving from one savings account to another. In fact, a move to dividend-paying stocks is an enormous change.

At first glance, dividends’ appeal is undeniable. Some well-known stocks like Verizon (Stock Quote: VZ), AT&T (Stock Quote: T) and Duke Energy (Stock Quote: DUK) yield more than 5%. Meanwhile, the 10-year Treasury pays just 2.86%, and five-year certificates of deposit average only 1.577%, according to the BankingMyWay.com survey. Ordinary bank savings yield just 0.154%.

For people with taxable accounts, the margin is even wider, as dividends are taxed at a maximum rate of 15%, while interest is taxed at income tax rates as high as 35%.

The investor’s first step is to compare both yields on an apples-to-apples, after-tax basis. Subtract your tax rate from one and multiply the taxable yield by the result. For a taxpayer paying 15% on dividends, that means multiplying 0.85 times the yield. With a 5% dividend, the investor would therefore keep 4.25%.

An investor in the 25% income tax bracket who owned a Treasury paying 2.86% would keep 2.145%, and the investor’s after-tax earnings on the five-year CD would be a paltry 1.18%.

But of course Treasuries are safe if you hold to maturity, and bank savings are insured against loss by the government. There’s no such safety in stocks, and it wouldn’t take much of a hiccup for a stock to lose more in price than it's earned in dividends.

That risk can be reduced somewhat by spreading money among a variety of dividend-paying stocks, though it would still be possible for a broad market decline to drag them all down.

Risks can also be managed by using stocks only for money you can afford to tie up for five years or longer, as stocks don’t often suffer price declines that last that long.

But even the long-term investor should keep on top of the news, analysis and financial reports involving each stock holding. Stocks are more work than bank savings and bonds.

Be especially wary of any stock with an exceptionally high dividend yield, which can be caused by a drop in the share price. If the company is in trouble, a cut in the dividend payment could follow.

Most importantly, if dividend-paying stocks still look appealing after all the risks are considered, it would still be wise to keep significant holdings in cash and bonds. Both serve to stabilize a portfolio that includes stocks, and bank holdings are always accessible in an emergency.

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