Building Long-Term Wealth with Stock Dividends
A dividend is a distribution of a portion of a company's earnings. Companies can choose to regularly reward their shareholders by paying dividends, usually in cash, although sometimes in stock.
One way for the average investor to build long-term wealth is by owning dividend-paying stocks. Historically, these stocks, which account for roughly 75% of companies in the S&P 500, have outperformed those that don't. You can earn passive income from their dividends and benefit from capital appreciation.
Generally found in sectors such as industrials, energy, and consumer staples… companies such as 3M, Procter & Gamble, Johnson & Johnson, and Coca-Cola have a long history of paying dividends and generally share some of their profits with investors when they generate more than management can efficiently reinvest in the business.
There's a misconception that dividend stocks are for retirees or risk-averse investors. You should consider buying dividend-paying stocks whenever you start investing to reap their long-term benefits. Dividend stocks, especially those in companies that consistently increase their dividends, have historically outperformed the market with less volatility.
Dividend yields enable an investor to quickly gauge how much they could earn in dividends by investing a certain amount of money in a stock. If a stock has a yield of 3%, you would earn $3 on every $100 invested, $30 on every $1,000 invested, and so on. A dividend yield also allows you to compare a stock to other income investments such as bank CDs or bond.
You can then:
- Reinvest to buy more shares of the company.
- Buy stock in a different company.
- Save the cash.
- Spend the money.
It's important to remember that paying stock dividends isn't obligatory in the same way that companies must make interest payments on bonds.
Smaller, faster-growing businesses need to retain their earnings to continue to expand, while large, established companies are already profitable with plenty of available cash.
Real estate investment trusts (REITs) have to pay dividends. The IRS requires that REITs distribute 90% of their taxable income to shareholders via dividend payments, and master limited partnerships (MLPs) have a similar cash distribution requirement.
Companies typically pay one of three types of dividends:
- Regular dividend: Usually paid quarterly, although they can also be paid monthly, biannually, or annually.
- Special dividend: This type of dividend is a one-time payment. A company might choose to pay a special dividend after a string of highly profitable quarters or because it sold an asset and doesn't have an immediate use for the money.
- Variable dividend: Variable dividends tend to be paid at fairly consistent intervals by companies that produce commodities such as oil and gas, timber, and mined materials but vary in amount depending on a company's earnings in the prior quarter or year. They’re paid in addition to regular dividend payments.
The amount of a company's dividend each quarter is voted on and must be approved by its board of directors. After the board of directors agrees on the amount of a dividend payment, the company officially announces its next dividend, known as the declaration date.
On the declaration date, the company indicates a date, known as the record date, on which you must be a shareholder in the company in order to receive the declared dividend payment. If an investor buys the stock on the record date, the investor does not receive the dividend. This is because it takes two days for a stock transaction to settle, which is known as T+2.
You must own the stock before the ex-dividend date. The ex-dividend date occurs one business day before the record date.
The payment date is the date on which the dividend payment is actually disbursed to shareholders. If a shareholder is receiving a dividend by mail, dividend checks are mailed on the payment date.
The IRS taxes most dividend income. The dividend tax rate depends on the type of dividend; qualified dividend, nonqualified dividend, or a return of capital, as well as the investor's income level, and the account in which they hold the investment.
A qualified dividend means it qualifies for the lower long-term capital gains tax rates. For 2022, those rates are 0%, 15%, and 20% depending on your income level. Non-qualified dividends, also known as ordinary dividends, are taxed at your ordinary tax rate, which ranges from 10% to 37%.
Not all dividends are taxable. For example, a dividend marked as a return of capital isn't taxed until an investor sells the underlying investment. Meanwhile, if you own the dividend stock in a tax-advantaged account, you are not taxed on dividends received.
The following account types exempt you from paying taxes on dividends, provided you do not withdraw money:
- Traditional IRA, or individual retirement account
- Roth IRA
- Simplified Employee Pension (SEP) IRA
- 401(k) plan
- Coverdell Education Savings Account (ESA)
- 529 plan
It's important to realize that a stock's dividend yield can change over time either in response to market fluctuations or as a result of dividend increases or decreases by the issuing company. So, the yield is not set in stone. A high dividend yield alone doesn't make a stock a great investment.