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Why Certificates of Deposit Suck & Dividends Rock

Posted By Jim On 02/07/2012 @ 7:15 am In Investing | 5 Comments

Take a quick peek at the best CD rates [3] and you’ll know that they’re abysmal right now. 1% for a 1 year CD? No more than 2% for a 5 year CD? Those are terrible yields.

Consider this – you can buy shares of blue chip companies with yields greater than 1-2%. You can start by looking at the dividend aristocrats [4] but ultimately you can easily find safe companies who have stable cash flows capable of supporting dividend yields much greater than 1-2% (and you’re taxed at a much lower rate!).

In the end, both are financial tools that serve a specific purpose. Knowing which to use can be crucial in getting a little more out of your money.

Principal Risk

There’s no such as a free lunch. In return for those higher yields, you put your initial investment at risk. Here is where knowing your financial needs becomes crucial.

Are you looking at a 5 year CD because you need income? Or do you intend to buy a house in 5 years and you’re simply looking for a good home for your cash until then? If protecting your principal is goal one and interest is simply gravy, then CDs are the answer. Never let the hope of more money (greed!) distract you from the importance of protecting what you already have. If you’re looking to generate income and the principal is less important, at least in the short term, a dividend stock might make more sense.

If you can hold it for five years, or longer, chances are you can weather the ups and downs that come with a publicly traded company. As we’ve seen, a lot can happen in five years and it’s crucial to avoid knee-jerk reactions (which is possible if you’re not as worried about principal).

On the flip side, you also benefit from stock appreciation and dividend increases, which can be significant.

Transaction Costs

Buying a CD is very simple and it only costs your time. You’ll need to open an account, if necessary, and then deposit funds into the CD. When you get paid interest, you’ll add a few seconds to tax preparation to deal with the 1099-INT the bank will send you.

When you buy shares in a company, it’ll cost you both time and money. In addition to the account setup, if necessary, you’ll pay a commission when you buy the stock. You’ll also get a 1099 from the broker at the end of the year detailing the ordinary and qualified dividends. Alternatively, you can avoid some of these transaction costs by investing in a mutual fund like Vanguard Dividend Growth Fund (VDIGX [5]), but you trade transaction costs for expense ratios.

Taxation

Here’s the big kicker – interest from a certificate of deposit is taxed as ordinary income. Dividends from a company, assuming they are qualified dividends [6], are taxed at long term capital gains. Ordinary income is taxed at your tax bracket [7] whereas dividend income is taxed at a much lower rate.

Assuming you’re in the 25% tax bracket, a 1% APY CD is really a 0.75% APY CD, after taxes. A 5% dividend yield company is actually a 4.25% dividend yield company, after taxes. That’s a significant difference.

For the last few years, I’ve been building onto the inner wall of financial fortress [8] and adding blue chip dividend companies. These aren’t the trendy hot tech companies like Pandora [9] or Zynga [10], we’re talking nice boring companies like Diageo [11], Conoco Phillips [12], and Kimberly Clark [13]. I like boring, especially if it pays slightly better than a CD.


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[2] Email: mailto:?subject=http://www.bargaineering.com/articles/certificates-deposit-suck-dividends-rock.html

[3] best CD rates: http://www.bargaineering.com/articles/best-cd-certificate-of-deposit-rates.html

[4] dividend aristocrats: http://www.bargaineering.com/articles/2012-sp-dividend-aristocrats.html

[5] VDIGX: https://personal.vanguard.com/us/funds/snapshot?FundId=0057&FundIntExt=INT

[6] qualified dividends: http://www.bargaineering.com/articles/qualified-dividend.html

[7] tax bracket: http://www.bargaineering.com/articles/sneak-peak-projected-2012-tax-brackets.html

[8] financial fortress: http://www.bargaineering.com/articles/understanding-your-financial-fortress.html

[9] Pandora: http://www.google.com/finance?q=P

[10] Zynga: http://www.google.com/finance?q=ZNGA

[11] Diageo: http://www.google.com/finance?q=DEO

[12] Conoco Phillips: http://www.google.com/finance?q=COP

[13] Kimberly Clark: http://www.google.com/finance?q=KMB

Thank you for reading!