Dividend Investing Basics: Taxes, Potential and More

If you want to generate a consistent revenue stream from your investments, dividend investing is often cited as one of the simplest—and safest—ways to do it. Just like any other normally traded equity, dividend-paying stocks (theoretically) appreciate in value over the long term. But unlike standard stocks, these holdings also pay investors while they wait.

If you’re unfamiliar with the term, dividends are consistent payouts a company makes to its shareholders on a per-share basis—usually on a quarterly basis, after the company reports results. The payout represents a small percentage of the company’s earnings. As a point of reference, the S&P 500 Index has a historic average dividend yield range of about 2–5%.

The Benefits of Dividend Investing

Aside from collecting a regular passive income, there are numerous benefits to dividend investing…

 

Stable companies

 

Dividend-paying companies tend to be more established and stable than companies without dividends. This is only logical, since a younger, less stable company is more likely to reinvest its earnings back into its growth. Dividends indicate that a company has reached such a level of stability (and sustainability) that the board of directors is willing to distribute profits.

 

Less risk

 

Aside from the fact that dividend-paying companies tend to be more stable on the whole, there’s the added factor that these names tend to have lower risk/reward profiles (since there are two ways for investors to realize value). As such, they tend to be less volatile, even during downturns in the market.

Offsets bear markets

 

 

Once a company issues a dividend, it’s usually hesitant to revoke it—even in a bear market. Doing so would be indicative that the company wasn’t doing well, and would undoubtedly cause anxious investors to flee. A regular payout in a bear market could go a long way in reducing your overall losses. Plus, dividend-paying stocks have historically outperformed during down markets.

 

Compounding reinvestments

 

Dividends give you the ability to purchase more shares without taking any additional money from your personal account. The particular benefit of this strategy is that not only are your number of shares increasing… so, too, is your dividend payment. Even if the stock does not appreciate dramatically in value, you’ll still see a higher return on investment.

It’s important to note, though, that since most dividend yields are around the 2–3% mark, it’s unlikely to accumulate to vast wealth unless and until you already have quite a bit invested.

Risks of Dividend Investing

There are a few risks associated with dividend investing. For instance, high-yield dividends may seem appealing, but the truth is they’re often correlated to riskier investments, like junk bonds. And dividends are never guaranteed, even if a company has historically paid one for hundreds of years. (This happened with several banks during the financial crisis.) Additionally, there’s some debate about whether dividends dilute growth potential, since it represents profits that are not being reinvested in the company.

Taxes

Dividend payments are counted as taxable income by the IRS. This is true regardless of whether you reinvest them.

Dividends are categorized in two ways for tax purposes: qualified and nonqualified. Qualified dividends must be from U.S.-based companies, or else companies that trade on a major U.S. exchange. And investors must have owned the shares for over 60 days of the holding period.

 

  • Qualified dividends are tax-free for individuals in the 10–15% tax bracket, contingent on the dividend not pushing them to a higher tax bracket. If it does, income from dividends is taxed at 15% for people in the 25–35% brackets and 20% for anyone in a higher tax bracket.

 

 

  • Nonqualified dividends are taxed at the standard income tax rates.

 

How to Invest in Dividends

There are several investment vehicles that offer dividends…

 

ETFs

 

Exchange-traded funds (ETFs) are one of the least expensive ways to invest in dividends. These represent baskets of dividend-paying stocks, so if one company cuts its dividend, it’s unlikely to dramatically impact your overall payout.

Like any investment, ETFs come in a wide range of sizes, sectors, and investment grades. As with any investment, you’ll want to research any ETF you’re considering adding to your portfolio to make sure it suits your investment needs.

 

Mutual funds

 

Mutual funds are another way to easily diversify amongst several dividend-paying holdings. However, mutual funds tend to come with much higher fees than some of the alternatives.

Individual stocks 

You can also buy individual dividend-paying stocks, as you would any other on the stock market. However, this method can be a little riskier, since you don’t have the immediate diversification at your fingertips. And just because a company pays a dividend by no means guarantees it’s a good investment. It’s important to look for names with strong fundamentals that will help your portfolio appreciate in value over time.

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