3 Top Dividend Stocks for Your Roth IRA

By Markets Fool.com

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Years of testing and experience have proven that dividend investing is one of the surest paths to financial independence. Although it isn't as sexy as investing in the next Silicon Valley start-up, the constant compounding that reinvesting your dividends creates can work miracles over time.

When it comes time to stash your dividend payers in a retirement account, I highly suggest considering a Roth IRA. That's because you've already paid taxes on the money, and all future dividends, reinvestments, and disbursements are completely tax-free. That's a big deal if you are a dedicated, buy-to-hold income investor.

With that in mind, here is why I think you should consider buying shares of conglomerate 3M (NYSE: MMM), soda and snack-maker Pepsi (NYSE: PEP), and pharma giant AbbVie (NYSE: ABBV).

A history of dividend payments and increases

To make the list of official Dividend Aristocrats, a company needs to have:

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  • Made dividend payments for at least 100 consecutive quarters (25 years)
  • Increased said payment at least once per year.

All three of the stocks on this list qualify on those metrics.

Stock

Current Yield

Years of Consecutive Increases

5-Year Dividend Growth Rate

3M

2.5%

57 Years

14%

Pepsi

2.8%

44 Years

8%

AbbVie

3.6%

2 Years

23%*

Data source: Dividendinvestor.com *Shows current growth rate since spin-out

You might be looking at AbbVie and wonder why it's included if it only has two years of dividend history. That's because the company was spun out of Abbot Labs -- a parent company that has increased its dividend for over 25 consecutive years.

The real key to focus on here is the rate at which these dividends have been growing. Imagine buying shares of 3M today. You get $4.44 per share, or a 2.5% dividend yield -- not bad, but nothing to write home about. However, if the dividend continues increasing by the same amount (14%) over the next decade, the yield on your original investment will be a whopping $16.46 per share -- or 9.1% -- per year.

If we do the same calculations with Pepsi and AbbVie, we get a dividend yield in 10 years of 6% and 27.9%. More than likely, AbbVie's growth will temper, but that doesn't change the fact that these have the potential to be massive returns on your original investment.

Enough free cash flow to make it happen

The most important metric for dividend investors to watch is the payout ratio from free cash flow (FCF). FCF is what the company brings in via operations during a year, minus any capital expenditures. It is from FCF that dividends are paid, so the lower the ratio, the better.


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Data source: Yahoo! Finance

Over the past 12 months, none of these companies has come anywhere close to the "danger zone" of using over 90% of FCF to pay its dividend.

The bottom line, however, is that all three of these companies could continue paying their dividend in tough economic times, and will likely continue their increases if the macro economy can avoid a meltdown.

Wide moats

A "moat" is another way of saying that a company has a sustainable competitive advantage. Without moats, a company's products would become commoditized -- that's good for consumers, but generally not so good for investors.

3M is an industrial conglomerate with many irons in the fire. Your office likely has glue, tape, or Post-it notes from 3M. But the company also has operations in healthcare, manufacturing, electronics, and transportation. The company's brand names, economies of scale, and its cash stash of over $1.8 billion provide a substantial moat.

Pepsi, on the other hand, relies almost solely on the power of its brands for a moat. Those brands -- which include the namesake soda, Gatorade, Mountain Dew, Lays, Doritos, Fritos, Quaker Oats, and more -- are very powerful. They help Pepsi enjoy better margins than rivals, as the company can count on customers paying a few cents more for each of these products.

AbbVie, on the other hand, is in a bit more precarious position. As a pharmaceutical company, it relies on patents to protect its moat. Those patents, however, expire -- and when they do, sales can fall off a cliff. Humira has been one of its best sellers over the years, but investors need to make sure the company is still piling money back into research and development to ensure a pipeline of future blockbuster drugs. The company's $8 billion in cash also gives it options for acquiring up-and-coming drug compounds.

When you add these three characteristics together -- a history of dividend growth, low payout ratios from FCF, and wide moats -- you have a recipe for long-term investing success. Throw those dividends in a Roth IRA, and you're looking at tax-free growth that can help you retire very comfortably.

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Brian Stoffel has no position in any stocks mentioned. The Motley Fool owns shares of and recommends PepsiCo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.