Many investors use dividend stocks to generate a steady income stream without relying exclusively on bonds and other fixed-income securities.
Others invest in dividend stocks to reduce risk since regular dividend payments can provide some support during market downturns. There are many reasons for investors to consider dividend stock investing.
Let’s look at how dividend stocks work, how to balance yield with safety, key metrics to watch, and how dividend taxes work.Dividend stock investing is an excellent way to build a steady income stream, but you should look at more than just yields to find the best opportunities. Click To Tweet
How Dividend Stocks Work
A dividend is a distribution of a portion of a company’s profits to its shareholders. Rather than relying exclusively on stock price appreciation, dividends enable investors to earn an income while holding a stock. These capabilities may appeal to retirees or others wishing to generate an income without necessarily selling their nest egg.
The decision to pay dividends is made by a company’s board of directors based on the company’s financial performance and capital requirements.
While some companies issue one-off “special dividends,” most are paid quarterly or annually. However, a company may choose to adjust, suspend, or eliminate them at any time.
There are three important dates for dividend investors to remember:
- Declaration Date – The date a company announces it will pay a dividend. The company also announces the dividend amount, payment date, and record date on this day.
- Ex-Dividend Date – The date on which a stock trades “ex-dividend,” meaning new investors won’t receive any dividend. This date is usually two business days before the record date.
- Payment Date – The date a company pays the dividend to shareholders.
Quick note, you may also see references to the Record Date. It is really nothing more than a bookkeeping issue at your broker. Just remember, you must own the stock before the Ex-Dividend Date to receive the payment.
While a company may announce a dividend as a certain amount of cash per share, most investors look at the dividend yield (or a dividend’s percentage of the stock price) rather than the cash amount. For example, a company paying a $4.00 cash dividend might have a 4% dividend yield if shares trade at $100 or a 5.3% dividend if they trade at $75.
Balancing Yield with Safety
Many novice dividend investors start investing in companies with the highest dividend yields. After all, these companies promise to pay the highest yield and generate the most income.
Unfortunately, a high dividend yield may indicate that the stock price has fallen significantly. For instance, the dividend yield in our example above rose from 4% to 5.3% but only because the share price fell 25% from $100 to $75. If the share price fell because the company was in financial distress, it may be at risk of cutting or eliminating the dividend!
High dividend yields may also prove unsustainable. If a company is paying out most of its profits as a dividend, there’s little room for the dividend to increase in the future, and a cut may be more likely. On the other hand, a low dividend yield could suggest that a business has more room to increase its dividend in the future.
Key Metrics & Indicators
Many investors look at metrics like price-earnings ratios or free cash flow yield to identify profitable companies trading at an attractive valuation. While these metrics can help identify undervalued stocks, dividend investors are typically more concerned with some of the problems we discussed in the previous section.
Track Your Dividends makes it easy to see key metrics in one place. Source: TrackYourDividends.com
Dividend investors should pay attention to a few key metrics:
- Dividend Yield – The annual dividend per share divided by the stock price, representing the percentage of the stock price paid out in dividends. A higher dividend yield may indicate more income potential for dividend investors.
- Dividend Payout Ratio – The percentage of a company’s earnings that are paid out in dividends. A lower payout ratio may suggest that a company has more flexibility to increase its dividend in the future.
- Dividend Growth Rate – The rate at which a company’s dividends have increased over time. A company with a long track record of consistently growing dividends may be seen as a more reliable dividend investment.
- Free Cash Flow – The amount of cash a company generates after accounting for capital expenditures. A company with strong free cash flow has more flexibility to pay dividends and potentially increase them in the future.
Of course, it’s also essential for investors to assess the underlying company’s financial health. Most dividend stock investors hold long-term positions, meaning you’ll want to find fundamentally sound companies with strong growth prospects. This might involve looking at factors like earnings growth or debt-equity ratios.
How Dividends Are Taxed
Dividend taxes depend on the types of dividends you receive and your tax bracket.
Most dividends paid by domestic or qualified foreign corporations are subject to advantageous long-term capital gains tax rates as long as you have held the stock for at least 60 days. However, short-term and non-qualified dividends are subject to ordinary income taxes. And in both cases, the amount you pay depends on your overall tax bracket.
2023 Ordinary Income Tax Brackets
|Tax Rate||Single Filers||Married, Filing Jointly|
|10%||$0 to $11,000||$0 to $22,000|
|12%||$11,001 to $44,725||$22,001 to $89,450|
|22%||$44,726 to $95,375||$89,451 to $190,750|
|24%||$95,376 to $182,100||$190,751 to $364,200|
|32%||$182,101 to $231,250||$364,201 to $462,500|
|35%||$231,251 to $578,125||$462,501 to $693,750|
|37%||$578,125 or more||$693,751 or more|
2023 Long-Term Capital Gains Income Tax Brackets
|Tax Rate||Single Filers||Married, Filing Jointly|
There are a handful of strategies you can use to reduce taxes:
- Tax-Advantaged Accounts – Dividends received in a tax-advantaged account, such as a 401(k) or Roth IRA, may not be subject to taxes. As a result, you may want to hold dividend stocks in these accounts versus taxable accounts.
- Long-term Holding Periods – Qualified dividends, which are taxed at lower capital gains tax rates, are generally only available to investors who have held the stock for at least 60 days. So, holding dividend stocks longer can reduce your tax rates.
The Bottom Line
Dividend stock investing is an excellent way to generate a steady income stream. However, investors should understand the ins and outs of dividends before investing to avoid common pitfalls. For instance, you shouldn’t exclusively look for high dividend yields or ignore a stock’s fundamental characteristics to maximize income.
If you’re interested in dividend stock investing, TrackYourDividends.com can help you screen for the best opportunities to increase the odds of success.
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