What is Dividend Investing?

by Kevin on July 26, 2012

Dividend investing is a popular strategy for a wide range of investors. Some choose dividend investing to supplement their income whole some rely heavily on dividend payments to cover their bills. What exactly is dividend investing, and is it a smart investment path for you? Let’s also look at some of the benefits of risks of selecting the dividend investment strategy.

Strategies for Dividend Investing

There are two many strategies that dividend investing is used for: retirement income and passive income.

Retirement Income

When you talk about dividend investing for retirement there are a few different camps of thought. Some retirees feel more comfortable investing their money with companies they know and are familiar with. They invest their funds into the shares of local utility companies that tend to have long, consistent dividend payouts. While there is no perfect guarantee a dividend paying stock will continue to pay out, many of these firms have, so retirees flock to them to bolster their retirement income.

Another camp is that which is simply trying to inject as much growth into their portfolio so that it will be as large as possible when they hit retirement. There are three ways to grow your portfolio:

  • Injecting more capital (investing more of your hard earned money)
  • Receiving higher returns (going from 6% annual returns to 9% annual returns)
  • Growing current capital without additional investment (being paid dividends that are reinvested)

These investors are not partial to firms in their local area. Instead they target firms that have:

  • Healthy dividend payments (generally a minimum of 3% or 4% yield is considered)
  • Consistent dividend payments (past performance is not an indicator of future performance, but generally if a company has paid dividends for 40 years, they will in the 41st year, too)
  • Consistently stable or growing dividend yields (you don’t want a company that pays 6% this year and 0.5% next year)

Passive Income

A separate strategy is to earn enough investment income to cover your monthly expenses. This is usually very difficult to achieve: you either have to have extremely low expenses and a lower but still sizable portfolio, or normal expenses and a very large portfolio.

For example, let’s say you spend $40,000 per year. If your portfolio paid out a generous 5% yield per year you would need a portfolio of $800,000 to cover those expenses. But wait, that’s before taxes. Since dividends are taxed at 15%, your nest egg now needs to produce $47,058 in investment income per year before tax. That means your portfolio would have to be $941,160.

It takes most people a lifetime to save up that much money, but if you can cut back on how much you spend and increase how much you have invested, this passive income goal can be achieved.

Benefits of Dividend Investing

Choosing investments that pay consistent dividends can be a wise choice for many reasons.

First, dividends are taxed at a lower rate than the rest of your income. In fact, you may not have to pay taxes at all on your dividend income. The tax rate for dividend income is essentially two different rates: 0% if your regular income tax rate is below 25%, and 15% if your regular income tax rate is 25% or more. Either way you pay less in tax on dividend income than you do on other income.

Second, dividend investing keeps you focused on the long term health of the company. You don’t buy into a dividend stock today in hopes of selling it next month for a large capital gain (which is then taxed at higher rates). You would much rather the firm pay a 5% dividend and grow slowly over time with consistent dividend payouts.

Risks of Dividend Investing

However, investing just for dividends can be a risky process. Getting tax-free or reduced-tax income is nice, but there are still some risks.

The main risk is chasing dividends and ignoring company financials. Some companies pay 8%, 10%, or 15% dividends because they are in horrific financial shape. These firms might have a stated yield that is very high, but they just received some bad news and are about to cut their dividend rate back to normal (or eliminate it entirely). You can’t just look for the highest yielding stocks and ignore the rest of the facts.

Is Dividend Investing Right for Me?

I’m intrigued by dividend investing, but building up a massive portfolio will take time just like it would normally. I’m not normally worried about my tax rate because a majority of my investments are inside a Roth IRA. It’s something I plan to learn more about in the future — and I’ll be sure to share my insights with you.

What about you?

{ 1 comment }

Derek July 31, 2012 at 2:39 pm

Dividend investing is a great way to help boost your overall returns from the stock market. But, like you said, an investor should be careful to avoid chasing after a higher dividend just for the dividend. I look at the company from the perspective of the ratios of dividend to earnings and of dividends to cash flow. If the company is paying out too much just to keep their dividends going, that is a sign that the company is struggling. This may hurt the appreciation in stock price which could completely nullify your dividends earnings if you were forced to sell the position for a loss. Overall, a solid company paying a decent dividend that can be purchased at the right stock price could turn out to be a great investment for your portfolio.

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