One of the main questions that I hear is, “How do I get started with dividend investing?” Beginners can always try to take the just jump in approach to dividend investing. This works for some things, but dividend investing is not one of them.
Since real money is being invested there is a risk of loss. In addition, market volatility often makes some new investors uneasy and prone to making poor decisions, especially if there is a downturn after buying shares. I prefer an educated approach to dividend investing and you should do so.
As a beginner, it is important for you to learn the basics of dividend investing so you can make knowledgeable decisions.
What Are Dividends?
Dividends are typically cash distributions that public companies payout on a periodic basis from their earnings to shareholders. Most companies pay dividends quarterly in the U.S. Some companies pay dividends monthly, and a few pay dividends bi-annually or annually. It is much more common for a European company to pay a dividend bi-annually or annually.
Dividends are a type of income that shareholders receive for each share of stock that they own. For example, let’s assume you own 100 shares of Company A, and Company A pays a dividend of $0.10 per share. This means that you receive $10 in cash when the dividend is paid each quarter.
Some companies also pay stock dividends. A few companies pay both cash and stock dividends. A limited number of companies pay special dividends, which are much more infrequent and can be paid at any time. Regardless of the type of dividend, dividends are set and approved by a company’s board of directors and also approved by the shareholders.
Basics of Dividend Payments
Dividend payment has four parts: an announcement or declaration date, an ex-dividend date, a record date, and a payment date.
- The announcement date is when the dividend is announced by the company.
- The ex-dividend date is the day when dividend eligibility expires. A shareholder must own the stock before the ex-dividend date to receive the announced dividend. Typically, this is one day before the record date.
- The record date is the cutoff date to determine which shareholders are eligible to receive the announced dividend.
- The payment date is when the company distributes the dividend to shareholders who are eligible to receive the dividend.
Why Dividend Investing?
The attraction of dividend investing has risen, especially since the Great Recession from 2008 – 2009. Interest rates on savings accounts, money market deposit accounts, and certificates of deposits or ‘CDs’ dropped so low that they no longer generated sufficient income for retirees.
For instance, if a savings account hypothetically had an interest rate of 4% before 2008 and 2% in 2010 then your income was cut in half assuming the principal remained the same. This leads to a roughly 50% cut in income in a couple of years.
If dividend yields are greater than the interest rates on savings type accounts then the attraction of dividend investing tends to increase. There is also the benefit of capital appreciation for dividend stocks.
Risks of Dividend Investing
There is a stipulation though. Stocks are riskier than savings accounts, money markets, or CDs. For example, savings accounts are typically insured for up to $250,000 by the FDIC in the U.S. However, stocks can lose value if the share price drops. Stocks are not insured so your original principal is at risk. In the worst case, a company can go bankrupt and you lose all your money.
In addition, dividends can be cut or suspended during periods of financial distress, like during the coronavirus pandemic. Many businesses had severely reduced revenue during the peak of the pandemic and thus were not able to pay their dividends.
You need to understand that companies are not required to pay dividends unlike interest on bonds. So, although the appeal of dividend investing has risen, dividend stocks are riskier than safer savings-type accounts.
Two Types of Dividend Investing
Dividend investing comes in two main themes. There are those that invest in yield or for income. Then there are those that are pursuing dividend growth investing. In either case, however, the main reasons to invest in dividend stocks are to generate wealth, create a passive income, or both.
Individual investors seeking current income, such as retirees, tend to focus on higher-yielding stocks. Companies that have high dividend yields often mature and have predictable earnings over time. They can pay out a larger percentage of their earnings since their earnings are often more predictable.
Stocks in the utility sector or consumer staples sector often fall into this category. Many utilities are regulated monopolies, leading to more predictable earnings over time. Consumer staple companies sell essentials or basic necessities, and this too leads to more predictable earnings.
The second type of dividend investing is dividend growth investing. Investors that pursue this type of investing are referred to as dividend growth investors or ‘DGI’. In this case, the focus is on the growth of the dividend and reinvesting it over time to build wealth and eventually passive income. This permits the dividend to compound over time.
There are advantages to this. Some research has shown that companies that grow their dividends have better annual returns with lower volatility as a group. In addition, the power of compounding allows you to build wealth.
Dividends and Taxes
Dividends are taxed because the IRS considers dividends as income. Dividends can be taxed at a lower rate than your regular income if the dividends are qualified. Qualified dividends are taxed at the long-term capital gains rate. Ordinary or non-qualified dividends are taxed at your regular income tax rate, which is typically a higher rate.
For example, distributions from REITs, MLPs, and some other types of special entities are not considered qualified dividends.
What is a qualified dividend? In order to be considered a qualified dividend the dividend must meet the following criteria:
- Paid by a U.S. company or a company in U.S. possession
- Paid by a foreign company residing in a country that is eligible for benefits under a U.S. tax treaty
- Paid by a foreign company that can be easily traded on a major U.S. stock market
- The stock must have been held for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date
Fortunately, you do not need to make this determination yourself. Instead, your brokerage firm must send you a Form 1099-DIV that states whether a dividend is qualified or ordinary. If you own shares in an MLP partnership, your dividend will be reported to you on a Schedule K-1.
Dividend investing is not for everyone. It takes patience, discipline, and research in order to do it correctly. There will be mistakes since no one bats 100% when dividend investing. That said, dividend investing can help you build wealth, passive income, or both.
You just need to understand the basics and risks before jumping in and buying dividend stocks.
Biography: Dividend Power is a leading blogger on dividend growth stocks, financial independence, and retirement. Some of his writings can be found on Seeking Alpha, ValueWalk, The Money Show, Forbes, Insider Monkey, TalkMarkets, Stockwitts, Yahoo Finance, and leading dividend investing blogs. He also works as a freelance equity analyst with a leading newsletter on dividend stocks.