Benefits of Dividend Paying Stocks
Investors look to dividend paying stocks to help provide them with a reliable stream of income. Investing in companies paying dividend yields can be viewed as the sensible approach to creating an overall investment portfolio. Think of dividends as a bonus to the price of stocks as they go up which is paid to you every three months. Even if stocks go down, dividends tend to remain a reliable source of money.
Companies Paying Dividends
Industries traditionally paying higher dividends include utilities and financial institutions, but that is not to say you should only invest in these two industries. This occurs for many different reasons, but if we use utilities as an example we can conclude that high dividends were often the result of limited reinvestment opportunities within the company. Let's take a closer look.
If you were the Financial Officer of a utility you have a choice to make at the end of each earnings period. Earnings can be used to pay down debt or to repurchase shares of common stock, adjusting the financial leverage of the company. You can also use earnings to reinvest in the company itself. Reinvestment in the company might be used if there is a lot of growth potential. Or, you can return earnings to your shareholders in the form of dividends.
Companies are always evaluating opportunities to use earnings in a way that provides the greatest benefits to the shareholders. Often the alternatives are limited for some companies.
For example, most utilities have a fixed territory. These utilities are in well developed state(s) which may not have a lot of opportunity to grow their business. They are limited by geographic size of their franchise territory. So the company makes a decision to return a larger proportion of its earnings to shareholders in the form of dividends.
Dividend Paying Stocks, Sensibility
Now that you have an understanding of why a company might offer shareholders a high dividend yield, you might be wondering what kind of yields are we talking about? Dividend yields can vary widely and just because they have done well does not mean they will continue to do well. Take for instance, General Motors which use to be a very reliable company to invest in with a fairly high dividend yield, but after the 2007 Recession it is in bankruptcy and currently it is advised the stock should not be owned or traded.
So, the moral of the story is this, just because a company did well in the past it is by no means a guarantee or an indicator of how it will do in the future.
Dividends and Taxes
Recent changes to the tax code makes the payment of dividends to investors even more attractive. That's because qualified dividends are now taxed at a lower rate than ordinary dividends. This has resulted in even higher dividend payouts from stocks of those companies already providing investors with a good yield.
Ordinary Stock Dividends
Ordinary dividends are paid out of the earnings and profits of a company. They are federally taxable as ordinary income unless they meet the standard test for qualified dividends. Said simply, ordinary dividends are those that do not meet the standards or requirements to be considered qualified dividends. (Check with your CPA who will know how to file the correct forms.)
Qualified Dividends
Qualified stock dividends are ordinary dividends received in tax years after 2002 that are subject to the same federal income tax rate as net capital gains (5 or 15 maximum tax rate). If your applicable "regular" tax rate is 25 or higher, then the qualified dividends are taxed at the new 15 capital gains maximum. If your "regular tax" rate is less than 25, then qualified dividends are taxed at the new 5 capital gains rate.
Capital Gains Eligibility Rules
For stock dividends to be eligible for the new capital gains rates, those dividends must meet all of the following requirements:
+ Dividends must be paid by a U.S. corporation or a qualified foreign corporation.
+ Dividends cannot be those that are specifically excluded from qualified dividends (included are capital gains, dividends from savings or other bank accounts, dividends on ESOPs – Employee Stock Ownership Plan).
+ Stock holding periods must also be met. Common stock: the holding period is more than 60 days of a 121-day timeline (60 days before the stock goes ex-dividend and 60 days after the ex-dividend date). Preferred stock: the holding period must be more than 90 days of a 181-day timeline (90 days before the stock goes ex-dividend and 90 days after the stock goes ex-divided).
Adding dividend paying stocks to any investment portfolio makes sense as they add a reliable income which can be used to reinvest in additional dividend paying stocks or other investments. Dividend payments can also be used to help, and continue to, fund a retirement plan. Once investments are large enough, dividends can in part provide a reliable source of income.
