When it comes to investing, there are many different strategies to use. One popular strategy is investing for dividend income. This strategy is especially popular with retirees because it produces a stream of passive income which replaces some of the “salary” they no longer have. It’s also a great strategy for investors with less risk tolerance than average. Here are some important considerations to think about if you are interested in implementing this strategy.
What is a dividend?
A dividend is a payout by a company to its shareholders of its earnings. The amount of dividends is determined by the Board of Directors of the company and is generally announced as a dividend per share of common stock. They are typically declared on a quarterly or annual basis. For example, if you own 100 shares of a company’s common stock and the board declares a dividend of $.05 per share – you would be entitled to $5 of dividends.
What do I need to know about investing for dividends?
Passive income – One of the main reasons investors look for dividends is to provide some passive income. Generally, the dividends can either be received as cash or can be set for reinvestment back into the mutual fund or ETF (Exchange Traded Fund) they were paid from. Retirees like the dividends because they replace income from their working years. Receiving the income also reduces the amount of principle that needs to be sold from the portfolio. If you are not yet retired and don’t need the dividends for living expenses, most funds allow you to automatically have the dividends reinvested right back into the fund. Another use of the dividends is to receive them in cash and then invest the cash into another fund in a different asset class within your portfolio.
Less volatility – The types of companies that pay dividends are generally large, older, well-established companies that don’t need to reinvest all their profits back into the company. These companies are generally considered to be less risky as an investment. They have been around for a long time, have weathered and survived past economic storms and are in a better position to continue to do so. For this reason, when the market hits a rough patch, investments in these types of companies usually do not decline in value as steeply as other companies. This makes investing in dividend paying companies a good option for investors who are more risk adverse.
Income and asset growth – Besides receiving the dividends, the value of the investment will also continue growing so you are receiving the income plus capital appreciation. Many companies also increase their dividends year after year as the company continues growing. There is one downside to dividend paying companies when it comes to growth though. That downside is that they grow at a slower pace than companies not paying dividends. This is because companies that are in the growth phase of the business cycle are reinvesting all their income back into the company for further expansion. For this reason, it is a good idea to make sure your portfolio is diversified and also contains investments that will grow at a faster pace.
Taxes – One consideration when investing in dividend paying companies is the tax implication of receiving the income. Dividends are either classified as ordinary or qualified. Ordinary dividends are included in your income and taxed at the ordinary income tax rates which currently go up to 37%. Qualified dividends are taxed at the lower capital gains tax rate which is typically 15% for most taxpayers. The IRS provides the requirements to be classified as qualified however, most dividends from US corporations are qualified, with some exceptions. For example, the dividends paid by a REIT (Real Estate Investment Trust) which are companies invested in real estate are considered ordinary. When investing for dividends, you will want to pay attention to which type of investment account you are using (taxable, tax-deferred, or tax-free) so you don’t get any surprises at tax time. Another thing to note about taxes on qualified dividends is that they have been taxed at the capital gains rate since 2003, but were previously taxed at the ordinary tax rates. Just keep in mind taxes can and do change over time.
Dividends are discretionary – One major risk of investing in dividends is that they are completely up to the company to pay them or not. During the financial crisis of 2008-2009, most of the major banks reduced or cut their dividend payments. Many of these companies had histories of paying increasing dividends for decades. When COVID hit, the same dividend slashing happened as companies began preserving cash due to the unknown. If you are relying on dividends for income replacement, you should make sure you have a back-up plan for periods when they may be reduced, such as an adequate amount of bonds and other fixed income asset classes in your portfolio you can pull from.
I’ve always been a fan of investing for dividends. It’s a good way for some extra passive income which is useful no matter where you are in your investing timeline. If you are interested in investing for dividends, just make sure you think about the above-mentioned details before adjusting your portfolio.
