Buying the stocks of companies that pay steady dividends is one of the best ways to invest. Because you’re investing for slow, steady payments in more mature companies, some might even call dividend investing boring. But steady returns are never dull.
Earlier generations of investors favored dividend investing—and while those earlier generations enjoyed generally higher yields than are available today, there are still plenty of benefits to a dividend investing strategy.
What Is Dividend Income?
When a publicly traded company generates profits, it has three choices for using cash. It can direct the funds into research and development, save money, or return the profits to shareholders as dividend payments.
Dividend income is like earning interest from a bank in exchange for holding your money in a savings account. If you own one share of stock valued at $100, a 5% annual dividend yield means the company will pay you $5 each year in dividend income.
For many investors, regular dividend income is a reliable, safe way to grow a nest egg. An investing strategy built on dividend income can be an essential part of any saver’s portfolio, especially as a cash flow source when turning lifelong investments into a retirement paycheck.
Just remember, there are advantages and disadvantages to understand before you invest in pursuit of dividend income. First and foremost: Dividends are never guaranteed, and companies can and do change them at will. In addition, they’re more commonly paid out by larger, more mature companies that are growing more slowly. Smaller, less established companies are more likely to reinvest their earnings back into themselves. They may experience more exponential stock growth, which is another way for you to grow your wealth.
Dividend Investing in Long-Term Portfolios
If you own stocks or index funds, you may be already involved in some degree of dividend investing: About 77% of S&P 500 stocks pay a dividend, for instance. And while the current dividend yield of the S&P 500 doesn’t sound like much—1.70%—it’s a heck of a lot higher than average savings account APYs or even Treasury bond rates. Still, it’s low from a historical perspective.
During most of the 20th century, the annual dividend yield of the S&P 500 ranged between 3% and 5%. More recently, dividend yields have decreased as companies have been more cautious with their cash payouts.
There are many reasons for this: Low savings account rates and bond yields provide dividend stocks with little competition. If savings accounts paid 3%, a 1.79% dividend wouldn’t sound very tempting, but there’s less incentive to raise dividends in the current interest rate environment. In addition, tech companies have become more critical in the last few decades. And as an industry, tech companies generally prefer investing in new products for fast growth rather than sending cash to shareholders.
How Dividend Reinvestment Boosts Your Returns
Despite these trends, dividends remain crucial to boost your overall investing returns. When you reinvest dividend payments to buy more shares of stock in your investments, you help your portfolio benefit from enhanced compounding effects. On a basic level, each dividend you reinvest entitles you to more dividend payments in the future, which can supercharge your investment returns.
Say you invested in an S&P 500 index fund starting in January 2000 and held your investment until September 2020. Your average annualized return based on stock price gains alone would have been 4.2%, for a cumulative return of 136%. Pretty good, right? But if you’d reinvested all dividend payments back in the fund over the same period, your annualized return would have been 6.2%, for a cumulative return of 247%. Just reinvesting dividends would have nearly doubled your gains.
Using this calculator, you can play with the numbers a bit, and you can find even more dramatic effects. Say you invested $10,000 in an S&P 500 index fund in January 1990. You’d have about $91,300 today based on price gains alone. But add in the dividend reinvestments, and you’d have nearly double that amount, or $180,000.
Tax Benefits of Dividend Investing
Dividend investing can provide valuable tax advantages for income investors. However, the Internal Revenue Service (IRS) doesn’t treat all dividends the same. There are two classes: “Qualified” dividends, taxed at the lower, long-term capital gains rate, and “unqualified” or “ordinary” dividends, which are taxed as regular income.
Most dividends paid by U.S. corporations are qualified dividends. That means that if investors own the stock for 60 days (in most cases), the income from dividends is taxed at the long-term capital gains rate. Certain other dividends—from Real Estate Investment Trusts (REITs) or master limited partnerships (MLPs)—are typically classified as ordinary dividends and taxed as regular income. Money market funds and other cash-like instruments also pay ordinary dividends.
Dividends received in tax-advantaged retirement accounts, like individual retirement accounts (IRA) or 401(k)s, aren’t subject to tax until you withdraw them.
How to Evaluate Dividend Stocks
The dividend yield is one tool for evaluating the best dividend-paying stocks. Many websites are devoted to helping investors find high-yielding dividend stocks, but just going with the highest dividend yield can be a bit deceiving.
Let’s say you’re looking at a stock that paid $5 in annual dividends and had until recently been valued at $100 a share. But the company’s business came under pressure, and its shares fell to $50—although it’s still paying $5 in annual dividends. In a relatively short period of time, the dividend yield would’ve doubled to 10% from 5%. In this case, the rising dividend yield is a sign of stress, not a sign of a healthy company.
A company with a declining share price might face problems, and its board may need to reconsider the dividend. This highlights reliability as a critical element for picking dividend-paying stocks. You need to ask yourself, “Is this company secure enough to keep paying the promised dividends—and perhaps even slowly increase them over time?” One place to find reliable dividend stocks is to look at stocks in the Dividend Aristocrats, a group of stocks that historically have increased dividend payments over time. Stocks in specific sectors, like real estate and utilities, may also pay higher dividends on average.
Another measure of good dividend stocks is the dividend payout ratio, which removes volatile stock prices from the equation by comparing a company’s earnings to its dividend payment per share. If a company earns $2 per share in a given quarter and pays a dividend of $1 per share, its payout ratio is said to be 50%.
Lower payout ratios should indicate more sustainable dividends—or a low payout ratio could mean that a company needs to increase its dividend. A payout over 100% indicates a company is returning more money to shareholders than it is earning, and it may need to lower its dividend—or its earnings are under pressure. On the other hand, a steadily rising payout ratio could indicate that a company is healthy and generating reliable returns in a mature industry.
