Right now, the best an expert can say about the stock market is that volatility may become the new normal and future returns will be unpredictable. While there are pockets of optimism in certain areas of the economy, the short- to medium-term prognosis for the stock market is clouded by numerous storm clouds.
Do not misunderstand; this is not a stock market prognosis. On the contrary, investors should continue to be cautiously optimistic and hold stock market investments, even though they are completely protected from volatility and unpredictability.
Investing in dividend stocks as a portfolio stabilizer and a source of profits in an unstable economy is one of the greatest ways to do this. We’ve put up this in-depth information to help you determine if dividend investing is good for you. Of course, in order to understand what you’re purchasing and why you’re holding it in your portfolio, you should always speak with your financial advisor.
Table of Content
- What is Dividend Investing?
- Examples of Companies With Consistent Dividends
- Understanding Dividends
- The Advantages of Dividend Investing
- Key Metrics in Dividend Investing
- Building a Dividend Portfolio
- Risks and Challenges in Dividend Investing
- Tax Considerations
What is Dividend Investing?
Investing in businesses that consistently provide shareholders a portion of their profits as dividends is the core of the dividend investing strategy. A cash dividend is the most direct means by which a company can influence the performance of its shareholders. All that a cash dividend represents is an investment return to the stockholders. The board of directors declares a dividend that is distributed to stockholders directly as cash or occasionally as shares, either annually or every quarter.
Periodically, the more successful businesses will raise their payouts. Since some businesses have been paying dividends for many years, it has become an expected strategy to draw in new investors. A business that begins paying a dividend will stop at nothing to keep doing so because it could be a sign that the business is in trouble.
Dividend stocks are not made equally. As with any investment class, it’s critical to set precise standards for choosing the stocks that fit your profile the best and adhere to a certain level of quality. Seeking the highest yields can be just as hazardous as buying junk bonds. In the long run, dividend income and capital appreciation will be higher for companies with a track record of consistent dividend payments, a clean balance sheet, and a promising earnings outlook than for higher-yielding assets.
Investing for the long run usually requires diversification. You can invest in a wide range of industries and dividend-paying securities using dividend stocks, including mutual funds, ETFs, common stock, preferred stock, and real estate investment trusts (REITs).
Examples of Companies With Consistent Dividends
In case you’re uncertain about which high-dividend stocks to select, investing in dividend funds can be a more suitable choice. Dividend-focused mutual funds and exchange-traded funds (ETFs) contain a portfolio of dividend-paying equities. While some of these funds concentrate on equities with high dividend yields, others search for businesses that have steadily increased their dividend payments over time.
Selecting a fund will relieve you of the burden of having to keep a close eye on each individual stock in the portfolio since the fund’s diversification should protect you from being overexposed to any one stock.
- 1. Pioneer Natural Resources (PXD)
Pioneer Natural Resources is an oil and gas exploration company that conducts business in the Midland Basin in West Texas. The company pays a base plus variable dividend that varies based on the company’s performance. It currently has one of the highest dividend yields in the S&P 500.
- Dividend yield: 7.1 percent
- Annual dividend: $16.47
- 2. Devon Energy (DVN)
Devon Energy is a producer of oil and natural gas and holds a portfolio of oil and gas properties in the U.S. The Oklahoma City-based company is focused on earning a competitive shareholder return within its peer group.
- Dividend yield: 6.8 percent
- Annual dividend: $3.45
- 3. Dow Inc. (DOW)
Dow is involved in the production of different chemicals that are used in a variety of industries. Its segments include packaging and specialty plastics, industrial intermediates and infrastructure, as well as performance materials and coatings. Dow is headquartered in Midland, Michigan.
- Dividend yield: 5.1 percent
- Annual dividend: $2.80
- 4. International Business Machines (IBM)
IBM is one of the largest tech companies in the U.S. and earns more than two-thirds of its revenue from software and consulting services. The Armonk, New York-based company has paid a dividend for over 100 consecutive years.
- Dividend yield: 4.5 percent
- Annual dividend: $6.64
- 5. Verizon Communications (VZ)
Verizon is a leader in communication and technology services. Along with AT&T and T-Mobile, they provide the majority of mobile phone services in the U.S. Verizon generated more than $135 billion in revenue in 2022.
- Dividend yield: 7.5 percent
- Annual dividend: $2.61
- 6. AT&T (T)
AT&T is another telecommunications leader that generates solid cash flow for shareholders. Recently, the company has divested some assets and cut its dividend by nearly half as it focuses on 5G investments and paying down its heavy debt load.
- Dividend yield: 7.8 percent
- Annual dividend: $1.11
- 7. Prudential Financial (PRU)
Prudential Financial is a global financial services company with various products including life insurance, annuities, retirement services, mutual funds and investment management. The company had nearly $1.4 trillion of assets under management at the end of 2022.
- Dividend yield: 5.3 percent
- Annual dividend: $5.00
8. Philip Morris International (PM)
Philip Morris sells cigarettes and smoke-free products in more than 180 countries outside the U.S. Though the company still generates significant profits from sales of tobacco-related products, it’s moving towards a greater focus on smoke-free products that, while not risk-free, present less of a health risk than cigarettes.
- Dividend yield: 5.1 percent
- Annual dividend: $4.50
- 9. Walgreens Boots Alliance (WBA)
Walgreens Boots Alliance operates retail pharmacies across the U.S., Europe and Asia. Its U.S. pharmacy business administered about 35 million COVID-19 vaccinations in its 2022 fiscal year. The company has a dividend history that dates back to 1989.
- Dividend yield: 7.5 percent
- Annual dividend: $1.92
- 10. 3M Company (MMM)
3M manufactures a variety of products that are used by businesses and consumers alike. The St. Paul, Minnesota-based company makes everything from building materials, electronics components and orthodontics to perhaps its best-known product: Scotch tape. 3M has paid a dividend to shareholders without interruption for more than 100 years.
- Dividend yield: 5.7 percent
- Annual dividend: $6.00
Dividend stocks or funds can be a great way to earn additional income. Keep in mind that if you own these securities in a taxable brokerage account, you’ll need to pay taxes on the income you receive, even if you reinvest those dividends. If you want to avoid taxes, you’ll need to own the shares in a tax-advantaged account such as an IRA or 401(k).
Be sure to research any dividend stocks carefully before investing. Some companies with high payouts today may be forced to cut the payments if their business suffers.
Dividends are regular payments of profit made to investors who own a company’s stock. Not all stocks pay dividends.
What Are Dividends?
A corporation pays dividends to its stockholders as a way of sharing profits with them. They are one way that investors can profit from their stock investments and are paid on a regular basis. Dividends may be given in the form of extra shares or as cash that may be withdrawn and reinvested or utilized as income. A stock dividend is the name given to this kind of payout.
All equities, however, do not offer dividends. You should especially consider dividend stocks, which you may have recently seen in the news, if you are interested in investing in dividends. This is due to the fact that dividend stocks can shield investors from the current high rate of inflation.
Companies that increase their dividend payments year after year are usually less volatile than the broader market. Some companies also respond to inflation by raising dividend payments. And the steady income from dividends can help smooth out a stock’s total return.
Types of Dividends
Usually, dividends are paid out on a company’s common stock. There are several types of dividends a company can choose to pay out to its shareholders.
- Cash dividends. The most common type of dividend. Companies generally pay these in cash directly into the shareholder’s brokerage account.
- Stock dividends. Instead of paying cash, companies can also pay investors with additional shares of stock.
- Dividend reinvestment programs (DRIPs). Investors in DRIPs are able to reinvest any dividends received back into the company’s stock, often at a discount. DRIPs typically aren’t mandatory; investors can choose to receive the dividend in cash instead.
- Special dividends. These dividends pay out on all shares of a company’s common stock but don’t recur like regular dividends. A company often issues a special dividend to distribute profits that have accumulated over several years and for which it has no immediate need.
- Preferred dividends. Payouts issued to owners of preferred stock. Preferred stock is a type of stock that functions less like a stock and more like a bond. Dividends are usually paid quarterly, but unlike dividends on common stock, dividends on preferred stock are generally fixed.
Why Do Companies Pay Dividends?
Dividends are often expected by the shareholders as a reward for their investment in a company. Dividend payments reflect positively on a company and help maintain investors’ trust.
A high-value dividend declaration can indicate that the company is doing well and has generated good profits. But it can also indicate that the company does not have suitable projects to generate better returns in the future. Therefore, it is utilizing its cash to pay shareholders instead of reinvesting it into growth.
A company with a long history of dividend payments that declares a reduction of the dividend amount, or its elimination, may signal to investors that the company is in trouble. AT&T Inc. cut its annual dividend in half to $1.11 on Feb. 1, 2022, and its shares fell 4% that day.
However, a reduction in dividend amounts or a decision against a dividend payment may not necessarily translate into bad news for a company. The company’s management may have a plan for investing the money such as a high-return project that has the potential to magnify returns for shareholders in the long run.
The dividend yield is a stock’s annual dividend payments to shareholders expressed as a percentage of the stock’s current price. This number tells you what you can expect in future income from a stock based on the price you could buy it for today, assuming the dividend remains unchanged.
For example, if a stock trades for $100 per share today and the company’s annualized dividend is $5 per share, the dividend yield is 5%. The formula is: annualized dividend divided by share price equals yield. In this case, $5 divided by $100 equals 5%.
It’s important to realize that a stock’s dividend yield can change over time, either in response to market fluctuations or as a result of dividend increases or decreases by the issuing company. So unlike a bond, the yield on a stock is not set in stone. It’s most useful as a metric to help determine if a stock trades for a good valuation, to find stocks that meet your needs for income, and to let you know if a dividend may be in trouble.
How to Calculate Dividend Yield
The formula for dividend yield is as follows:
Dividend Yield = Annual Dividends Per Share Price Per Share Dividend Yield = Price Per Share
Annual Dividends Per Share
The dividend yield can be calculated from the last full year’s financial report. This is acceptable during the first few months after the company has released its annual report; however, the longer it has been since the annual report, the less relevant that data is for investors. Alternatively, investors can also add the last four quarters of dividends, which captures the trailing 12 months of dividend data. Using a trailing dividend number is acceptable, but it can make the yield too high or too low if the dividend has recently been cut or raised.
Because dividends are paid quarterly, many investors will take the last quarterly dividend, multiply it by four, and use the product as the annual dividend for the yield calculation. This approach will reflect any recent changes in the dividend, but not all companies pay an even quarterly dividend. Some firms, especially outside the U.S., pay a small quarterly dividend with a large annual dividend. If the dividend calculation is performed after the large dividend distribution, it will give an inflated yield.
Finally, some companies pay a dividend more frequently than quarterly. A monthly dividend could result in a dividend yield calculation that is too low. When deciding how to calculate the dividend yield, an investor should look at the history of dividend payments to decide which method will give the most accurate results.
A company that regularly increases its dividend distribution each year and is included in the S&P 500 index is known as a dividend aristocrat. If a corporation has regularly raised its dividends for at least the previous 25 years, it will be regarded as a dividend aristocrat. Dividend aristocrat enthusiasts also rank them based on other criteria, like company size and liquidity—having a market capitalization of more than $3 billion, for example.
Companies that are able to maintain high dividend yields are relatively rare, and their businesses are usually very stable. They tend to have products that are recession-proof, allowing them to keep taking in profits and paying dividends even while other companies are struggling.
There are usually fewer than 100 dividend aristocrats at any given time. In 2021, just 65 dividend aristocrats were listed among the Standard & Poor’s 500. They can be found in many sectors, including health care, retail, oil and gas, and construction.
Startup companies and high flyers in technology rarely offer dividends at all. Their management teams prefer to reinvest any earnings back into the operations to help sustain higher-than-average growth. Some fledgling companies even run at a net loss and don’t have the cash on hand to pay dividends.
Large, established companies with predictable profits are better dividend payers in general. Many do not enjoy regular, robust growth or a constantly rising stock price. These companies tend to issue regular dividends as an alternative way of rewarding their shareholders.
Benefits of Investing in Dividend Aristocrats
A company that pays out an ever-increasing dividend is ideal for investors looking for stable income, and being such a company is a positive signal that the firm is on sound financial footing. Remember, however, that a dividend is a portion of a firm’s profits that it is paying to its owners (shareholders) in the form of cash—any money that is paid out in a dividend is not reinvested in the business.
If a business is paying shareholders too high a percentage of its profits, it may be a sign that management prefers not to reinvest in the company given a lack of growth opportunities. Therefore, a dividend aristocrat may be squandering growth opportunities, or not have any such opportunities to redirect profits.
Moreover, company management can use dividends to placate frustrated investors when the stock isn’t appreciating. That said, if a dividend aristocrat is able to grow the payout it gives to shareholders on a regular basis, it does imply some organic level of growth in order to fund those payments.
- Provides stable income for shareholders
- Is a positive signal indicating strong financials
The Advantages of Dividend Investing
Companies that pay dividends annually provide a percentage of their net revenue to stockholders and reinvest any leftover profits into their operations. These dividend stocks can be an excellent method to add passive income to your investment portfolio because they pay out cash to their owners on a regular basis.
Beyond the appeal of passive income, dividend stocks have many other advantages. However, as with any investment, one should weigh the pros and cons of dividend investing before making a commitment.
1. Generate Passive Income
Most investors like dividend stocks because of the fact that they can provide a steady source of income with little or no work, much like interest from a bank account but with a greater potential for return on investment.
Although expecting dividend-paying companies to continue to make good on their dividend payouts may sound a little risky, the fact is that mature, well-established companies will go to great lengths to not only keep their dividends consistent and predictable but to increase the amounts paid out on a regular basis.
Stable dividends are one of the most important factors in a company’s ability to keep its stock price strong, and dividend-paying companies make it a priority to do whatever is necessary to maintain a healthy financial position.
2. Take Full Advantage of Compounding
Compounding is a powerful way to increase your income by using earnings to generate even more earnings. Through compounding, you can earn more income without having to invest any additional money of your own, simply by letting your earnings go to work for you.
In the case of dividend investing, when you use your dividend earnings to purchase additional shares of company stock, you’ll earn more money because every share you purchase earns its own regular dividend payout.
This compounding strategy benefits from the power of exponential growth: your original investment generates a certain return that can be reinvested to produce greater returns, and those returns can be reinvested, and so on. The longer you continue to reinvest, the more quickly your returns will grow.
3. Invest Once and Profit Twice
When you invest in dividend stocks, you stand to profit in more ways than one. We already understand the potential for regular payouts offered by dividend investing, but there is also a return on investment when your share prices increase.
Non-dividend-paying stocks only offer a potential for profit when you buy their shares at a low price, and sell them for a higher one.
Dividend stocks, on the other hand, allow you to share in company profits while also retaining ownership of your investment. And since a large number of dividend-paying companies are financially stable and relatively reliable, their stock prices tend to increase over time, as their perceived investor value continues to grow.
4. Maximize Returns with Dividend Reinvestment
We know that reinvesting dividend earnings is an effective way to take advantage of the power of compounding, but it can become even easier and more convenient when you use a DRIP, or dividend reinvestment plan.
As a program that allows investors to automatically reinvest their cash dividends back into additional company shares, DRIPs combine the advantages of both compounding and dollar-cost averaging. These automatic share purchases generally occur on a company’s dividend payment dates and may be managed by the stock company itself, or by an outside agent or brokerage.
One of the best features of many DRIPs is that they allow you to buy additional company shares commission-free, or at a discount
5. Dividends Preserve Purchasing Power of Capital
Dividends also help out in another area that investors sometimes fail to consider: the effect of inflation on investment returns. For an investor to realize any genuine net gain from an investment, the investment must first provide enough of a return to overcome the loss of purchasing power that results from inflation.
If an investor owns a stock that increases in price 3% over the course of a year, but inflation is at 4%, then in terms of the purchasing power of their capital, the investor has actually suffered a 1% loss. However, if that same stock that increased 3% in price also offers a 3% dividend yield, the investment has successfully returned a profit that outpaces inflation and represents an actual gain in purchasing power for the investor. The good news for investors in dividend-paying companies is that many dividend yields outpace inflation.
Dividend stocks tend to be less risky than non-dividend stocks overall, but in order to make the most of everything they have to offer, you should become familiar with both the pros and cons of dividend investing before attempting to put them to work as part of your investment portfolio strategy.
Key Metrics in Dividend Investing
The practice of investing in dividends has grown in popularity among those looking to generate a consistent income. Investors can benefit from both price growth and cash dividends by making investments in premium, well-paying dividend equities.
The six most crucial metrics to monitor when buying dividend equities are listed below.
The dividend yield is the yearly return on your investment. It is calculated by taking the annual dividend divided by the stock’s current price. For example, if a company pays a dividend of $1 and its current stock price is $20, the dividend yield is 5%. Generally, a higher dividend yield is considered more attractive, as it means that investors are receiving higher yields for less investment.
It’s important to note, though, that higher yields also indicate greater risk as they can reflect instability in a stock or an impending departure of a cash dividend.
The payout ratio is the percentage of earnings that are paid out to shareholders as dividends. It is calculated by taking the total amount of dividends paid divided by total earnings per share. For example, if a company’s earnings per share are $5 and $2.50 is paid out in dividends, the payout ratio is 50%.
A high payout ratio indicates that a company is using a substantial portion of its income to pay out dividends, meaning that there is more of a chance that dividends may be cut in the future. On the other hand, low payout ratios indicate that a company is making most of its earnings in-house, rather than paying out to shareholders.
Dividend growth is a metric that indicates how quickly a company is raising dividends over time. It measures the percentage increase in dividends over a certain number of years. For example, if a company had raised dividends by 10% over the past three years, the dividend growth rate over that time would be 3.3%.
Investors generally look for companies that have a positive, consistently growing dividend. Companies that have a long history of dividend increases demonstrate that they are committed to returning value to shareholders and that they can be trusted with their cash dividends.
Dividend streak shows how many years a company has paid the same or higher dividend rate. It is a measure of how experienced the company is at providing dividends and how consistent they have been in increasing the dividend amount.
A long dividend streak is especially attractive as it indicates stability and suggests that the company has strong financials and management.
Companies that have the longest dividend streaks are known as Dividend Aristocrats (stocks with 25+ years of consecutive dividend increases) or Dividend Kings (stocks with 50+ years of dividend increases).
Free Cash Flow
Free cash flow is a fundamental measure of the cash a company generates after all its expenses. This metric is important when looking at dividend stocks because it shows how much cash a company has available to pay out to shareholders in the form of dividends.
Companies with strong free cash flow generally have more money to invest in dividends, making them more attractive options. While the payout ratio is also important for dividend stocks, taking both of these metrics into consideration gives a better overall picture of a company’s dividend health.
Debt to Equity Ratio
The debt-to-equity ratio shows the amount of debt compared to the amount of owners’ equity in the company. High debt levels generally indicate a company has taken on too much leverage, which increases the risk that the company may not be able to pay its dividend obligations.
A higher debt-to-equity ratio is usually unhealthy because it indicates that management may be risking too much and could eventually face cash flow shortages. That said, some are willing to take the extra risk in order to receive a greater return in the form of higher dividends.
Building a Dividend Portfolio
Dividends are a popular choice for income-seeking investors due to their benefits over bonds and bank deposit accounts. In addition to supplying a steady income flow, dividends may also let investors take part in the asset’s appreciation. In addition, dividends, if kept for a sufficient amount of time, offer advantageous tax treatment. Seek advice from a financial expert to assist you in creating your own dividend-focused portfolio.
To create your dividend portfolio, it helps to incorporate these features into your investment strategy.
Taxable vs. Retirement Account
When you invest in dividend investments within a retirement account, you do not have to worry about the tax status of the dividends. However, when investing through a taxable brokerage account, try to time your purchases so that your dividends are qualified. Qualified dividends are taxed at the same rates as long-term capital gains.
Individual Stocks vs. Mutual funds/ETFs
You can invest your dividend portfolio in stocks, mutual funds or ETFs. Each has its own unique pros and cons. With individual stocks, you can hand-select which companies to own and which to sell. Additionally, you can choose the timing of your purchases to ensure that you receive qualified dividends.
Mutual funds and ETFs offer instant diversification of your portfolio and professional management that chooses individual companies on your behalf. These funds buy and sell stocks regularly, so you may receive a mix of qualified and non-qualified dividends, as well as short- and long-term capital gains through no fault of your own.
Consistent Track Record
When analyzing potential investments for your dividend portfolio, look for a consistent track record of dividend payments. A company that has paid its dividends every period without fail is often a better choice than one that has started and stopped payouts numerous times. Additionally, companies that regularly increase dividends can help you keep up with inflation and boost your income.
Sector Investing in Your Dividend Portfolio
Some sectors pay dividends more than others. Utilities, telecommunications and consumer staples historically have offered the highest dividend yields. Conversely, small company stocks and technology companies tend to reinvest their earnings to grow revenues, so many of these companies tend not to offer dividends. Or, if they do, the yields are much lower on average.
While you are building your dividend portfolio, don’t forget to diversify your investments. Concentrating your money in one stock or sector can increase risk dramatically within your portfolio. Mutual funds and ETFs automatically provide diversification at the company level, but they can still be concentrated in a particular geography, sector or asset class.
Building a dividend portfolio is a smart way to create consistent income. With this strategy, you’re earning money on a regular basis, while also participating in the growth of the underlying stocks and potentially benefiting from tax advantages as well.
Tips for Creating a Dividend Portfolio
- Retirees have numerous options when it comes to creating retirement income. A mix of Social Security, pensions, a dividend portfolio, and other investments can often meet their needs. Growing your portfolio can generate larger dividends in the future. See how big your portfolio can get using an investment calculator and changing the amounts, timeframe, and annual rates of return.
- It can be challenging to pick the right dividend portfolio investments, but a financial advisor can help. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you.
Risks and Challenges in Dividend Investing
For astute investors, high-dividend stocks can offer outstanding prospects. Who wouldn’t be thrilled to receive a fat return on their investment? Investors should use caution when pursuing high-yield equities, as the situation may not always be as it seems.
A company’s large dividend may indicate financial difficulties that could jeopardize its capacity to pay dividends in the future, as shown by a notable decline in the share price of the company’s shares. Investors should also understand the risk associated with rising interest rates and how dividend stocks lose value in such an environment. Below, we go into further depth about these possible issues.
High Dividends Can Be Fool’s Gold
While high dividends have a natural appeal, investors should be careful they are not buying fool’s gold. An investor should ask, why is the dividend yield so high? In some cases, a high dividend yield can indicate a company in distress. The yield is high because the company’s shares have fallen in response to financial troubles. And the high yield may not last for much longer. A company under financial stress could reduce or scrap its dividend in an effort to conserve cash. This in turn could send the company’s share price even lower.
For example, suppose Company XYZ trades at $50 and pays a $2.50 annual dividend for a 5% yield. A negative external shock sends the stock to $25. The company may not cut its dividend immediately. Therefore, at a superficial glance, Company XYZ appears to now be paying a 10% dividend yield.
However, this high yield could be temporary. The same catalysts that cratered the stock price could lead Company XYZ to reduce its dividend. At other times, a company might elect to keep its dividend intact as a reward to loyal shareholders. Thus, investors should look to a company’s financial health and operations and determine whether its dividend payments can be maintained.
Key factors to investigate are the company’s free cash flow, historical dividend payout ratio, historical dividend schedules, and whether the company has been increasing or decreasing payments. Many of the best dividend payers are blue-chip companies with a steady record of producing revenue and income growth over multiple quarters and years.
With strong underlying fundamentals comes a reputation for consistent dividend payments. That said, there are always new companies establishing themselves as dividend payers, while others struggle to establish a record of consistency that investors crave. It’s important for investors to maintain steadfast due diligence.
Interest Rate Risk
High-dividend stocks are among a group of assets that are subject to interest rate risk. Generally speaking, high-dividend stocks become more attractive as interest rates fall. But when the Federal Reserve tightens monetary policy by raising interest rates, dividends become less attractive to investors, leading to an outflow in equities in general and dividend stocks in particular.
This is because investors compare yields with the risk-free rate of return they can earn by holding a government bond such as a Treasury bond. Let’s return to our earlier example of Company XYZ, which pays a dividend yield of 5%. If interest rates rise from 2% to 4%, suddenly that 5% yield becomes less attractive. This is because most investors will prefer the safety of a guaranteed 4% return, rather than risk their principal for an extra 1% yield.
As of September 2020, the low-interest rate environment favors dividend stocks. The Federal Reserve target for the federal funds rate, which is the overnight bank lending rate against which many other loans are benchmarked, is set at 0% to 0.25%. The Fed lowered the rate by 100 basis points on March 16, 2020, in response to the challenges facing the economy amid the 2020 crisis. Rates haven’t been this low since 2008, when the Fed eased monetary policy amid the 2007-2008 Financial Crisis. Rates stayed low through 2015, when the Federal Reserve slowly began raising them in tune with an improving economy.
A qualified dividend is an ordinary dividend that can be reported to the IRS as a capital gain rather than income, which for some taxpayers—but not all—represents a significant savings in taxes owed on the dividends. As of the 2023 tax year, individuals earning over $41,675 ($83,350 if married and filing jointly) pay at least a 15% tax on capital gains; if you earn less, you only pay income taxes. Ordinary dividends are payments made by public companies to owners of their common stock shares. They are the owners’ portion of the company’s profits and a reward for holding onto the shares.
Dividends are separated into two classes by the IRS, ordinary and qualified. A dividend is considered to be qualified if you have held a stock for more than 60 days in the 121-day period that began 60 days before the ex-dividend date. It is an ordinary dividend if you purchase it after the ex-dividend date.
The ex-dividend date is one market day before the dividend’s record date. The record date is the date at which a shareholder must be on the company’s books to receive the dividend.
For example, imagine you owned XYZ stock, which declared a dividend payment on Nov. 21 and set a date of record for a month later, Dec. 19. If you bought XYZ stock less than 60 days before Dec. 19 and received a dividend, it will be counted as ordinary income on your tax return for that year.
If you bought XYZ stock more than 60 days before the record date and held it for at least 61 days in the 121 days before the next dividend, you’d pay the capital gains tax rate on the dividend.
Capital gains are currently taxed at a rate of 0%, 15%, or 20%, depending on the taxpayer’s income. If you have capital gains from selling collectibles or qualified small business stock, you might pay up to 28%. Unrecaptured gains from selling section 1250 real property is taxed at up to 25%. So, most investors pay zero or 15%, with only the highest earners paying the 20% rate.
There are several other requirements for qualified dividends:
- The dividend must have been paid by a U.S. company or a qualifying foreign company.
- The dividends are not listed with the IRS as those that do not qualify.
- The required dividend holding period has been met.
IRS Form 1099-DIV, Box 1a, Ordinary Dividends sent from your broker shows all your dividends. Qualified dividends are listed in Box 1b on form 1099-DIV and are the portion of ordinary dividends from Box 1a that meet the criteria to be treated as qualified dividends.
Qualified Dividend Tax Treatment
Qualified and ordinary dividends have different tax implications that impact your net return. Internal Revenue Service. The tax rate is 0% on qualified dividends if your taxable income is less than $41,675 for singles and $83,350 for joint married filers.
If you make more than $41,675 (single) or $83,350 (joint), you’ll have a 15% tax rate on qualified dividends. If your income exceeds this, your capital gains tax will be 15%—at least to the upper threshold of the bracket.
Note that there is an additional 3.8% Net Investment Income Tax (NIIT) on investment gains or income. The IRS uses the lowest figure of your net investment income or the excess of your modified adjusted gross income (MAGI) that exceeds $200,000 for single filers, $250,000 for married filing jointly, and $125,000 for married filing separately to determine this tax.
So, to incur the NIIT, your MAGI must exceed the previously listed thresholds.
The ultimate tax rate a taxpayer pays on dividends depends on the taxpayer’s taxable income (and associated marginal tax rate) in addition to the type of dividend received. Qualifying dividends are assessed their own rate up to a maximum rate of 20%, though some of these dividends may be taxed at a marginal rate as low as 0%.
Many investors seek additional cash flow by investing in dividend-issuing securities. Some securities are tax-exempt, while other types of dividends held within certain retirement accounts is non-taxable. However, qualified dividends are taxed at a rate based on a taxpayer’s marginal income rates. Qualified dividends can be taxed at a rate up to 20%, and a taxpayer may need to fill out additional tax schedules to support the income.
Following the collapse of the tech bubble in the first half of 2022, dividend investment began to gain traction. According to how the stock market operates, demand for dividend stocks is higher in weaker economies and growth stocks are higher when the economy is expanding.
Economic growth was hampered by rising interest rates. Investor attention was drawn to low-risk bank deposits by a 5% interest rate. When you can earn a guaranteed return of 5% on fixed deposits, dividend stocks have to give larger rewards for the risk that comes with the stock market.
This risk-return trade-off puts downward pressure on dividend stocks. When the dividend stock price falls, the yield rises. The yield is the annual dividend per share as a percentage of stock price. Let’s take the example of Enbridge. It is an evergreen stock with a 7.6% yield ($3.55/$46.22). Its fundamentals have also been good as oil and gas demand recovered to the pre-pandemic level. After surging 37% between January 2021 and June 2022 in the pandemic recovery, the stock fell to its pandemic level of $44–$46.
One of the reasons behind this dip was the need for a yield above 5%. If you notice the trend, the stock fell between June 2022 and July 2023, when the interest rate surged from 0.25% to 5%. Many economists believe the interest rate has peaked, and the Bank of Canada will start cutting the rates from 2024 onwards. As interest rates fall, Enbridge’s stock could rise. Now is a good time to shift from bank deposits to dividend aristocrats like Enbridge, as they could give you a 7% yield and 10–12% capital growth.
The next growing dividend sectors are real estate and telecom. These sectors are currently going through some capital inefficiencies. But they could give long-term dividends as they mature and become more efficient. BCE and CT REIT are good alternatives within these sectors. CT REIT is among the few REITs growing its dividends at an average annual rate of over 3%.
You can boost your dividend portfolio when the economy is weak or interest rates are at their peak. The risk premium these stocks will give in the form of higher yields can compound your passive income in the long term.