Dividends In Action: How They Work And What To Do With Them
Let’s say you have 10,000 shares of Ford Motor Company, which pays quarterly dividends. At $0.15 per share, this translates to an annual interest payout of around $1,500. If you don’t need the cash immediately, you can re-invest those dividends back into the company.
All dividend stocks give investors the option to invest the dividends back into the company. This is typically a good idea, unless you have a large holding (say, hundreds of thousands of shares).
3 Key Benefits
- If you’re in it for the long-term, dividend investments can be especially rewarding. Dividends can make up roughly 45% of your total return if you re-invest. (Total return calculates dividend payments.)
- Investors who build up a portfolio of dividend-paying stocks over a long period of time should have a large number of shares by retirement age—and more shares means more income. Over time, $50 in dividend income grows to $100, then eventually to $1,000 and beyond. It adds up. In 10 years, that’s over $10,000 in dividend income that gets rolled into equity.
- Dividends are less volatile than earnings over time. The companies that offer them don’t like telling investors that they’re not going to get them any longer, so the firms that tend to issue dividends – even on the lower end of the credit rating scale – are generally established, cash-rich and can ride out tough markets.
1 Key Risk Factor
- When your dividend fund pays you, it goes into the entire portfolio. If the prices are high at the time of reinvestment, you’ll potentially be stuck buying at the top. The fund will distribute the cash across the weighting in the portfolio, meaning that you can’t simply buy more shares of your favorite firms in the fund.
If you like a little more control, you may want to work with an advisor to build your own portfolio with a range of investment-grade bonds to higher yielding firms and global equities rather than tracking an index.
Dividends count as taxable income regardless of what you do with them after they’re paid out. For tax purposes, dividends are categorized as “qualified” or “nonqualified.”
Qualified dividends are:
- Tax-free for those in the 10-15% tax brackets so long as the income from those dividends does not push the investor above that tax bracket
- If it does, then dividend income is taxed at a 15% rate for those in the 25-35% tax brackets and 20% for those above it
Nonqualified dividends are simply taxed at regular income tax rates.
Investors get a tax form at the end of the year showing how much they received in dividend income.
How To Invest In Dividend Stocks
Here are a couple options to get you started:
- Dividend mutual funds are the most diversified way into the market. There are always fees associated with managed funds, so it’s important to research the options thoroughly. Beating the benchmark is becoming harder and harder for active money managers, no matter the type of fund.
- Exchange traded funds (ETFs) are the cheapest way in. Like the mutual fund products, the ETF dividend product line runs the gambit from investment grade credit to speculative grade credit. Speculative grade bonds trade below triple B are often referred to as “junk bonds.” In the equity world, high yield dividends tend to have lower credit ratings, which is how they earned the term “junk.” Depending on your appetite for risk, however, this type of corporate equity has the potential for a higher yield.
In sum, dividend-paying investments can be a powerful addition to your portfolio -- especially when placed in tax-sheltered accounts like a rollover IRA. FutureAdvisor’s portfolios smartly incorporate dividend-paying ETFs into your holdings and place them as intelligently as possible within your portfolio (e.g. sheltering them from taxes whenever possible).