Advantages of Dividends in Your Portfolio: By WealthTrust-Arizona
Most of us equate a company’s steadily increasing dividends with its robust health and stability. As a result, corporations usually shy away from cutting dividends, so as to avoid the appearance of weakness.
Until relatively recently, many investors did not consider dividends to be relevant, considering them a throwback to an earlier era – like an automaker producing huge, gas-guzzling SUVs struggling to be taken seriously in a hybrid era.
How times change. Since 2003, when the top federal income tax rate on qualified dividends was reduced to 15% from a maximum of 38.6%, dividends have attained renewed respect.
Investors are attracted to more than the favorable tax treatment given to dividends. The ability of dividends to provide income and also, potentially, offset market volatility makes them attractive to investors. With Baby Boomers approaching retirement age and focusing more on income-producing investments, the demand for top-tier dividends is probably going to increase.
Why Should You Consider Dividends?
Since 1926, dividend income has made up a large percentage of the total return of the S&P 500. The portion of the total return from dividends has ranged from a 1940s high of 53% to a low of 14% during the 1990s, when investors were focused on growth.
Over time, if dividends are reinvested their impact becomes more dramatic. Standard and Poor’s estimates that $1 invested in the S&P 500 in December, 1929 would have grown to $57 over the next 75 years. When combined with reinvested dividends, that same dollar would have been worth $1,353. Of course, taxes were not factored into these calculations and past performance is no guarantee of future results.
If the price of a stock rises 8% a year, a 2.5% dividend yield can push its total return into double digits. Dividends can be particularly attractive in periods of relatively low returns and, in some cases, dividends can help a negative return become positive as well as lessening the impact of a volatile market.
A viable argument has been made that dividends are a reliable bellwether of the financial health of a company. In recent years, investors have become more cognizant of the value of reliable data in making investment decisions, and dividend payments cannot easily be massaged or restated.
Many stocks which pay high dividends are from larger, well-established companies which possess the resources necessary to withstand an economic slump, which could prove useful if you rely on dividends to help pay for living expenses.
The Corporate Incentive
While other market sectors have begun to offer them, traditionally investors have looked to utility and financial companies for dividends. Investors have been pressuring companies in cash-rich sectors, such as technology, to distribute at least some of their profits as dividends, in lieu of reinvesting that money to spur growth.
Some investors believe in putting pressure on companies to maintain or increase dividends as a means of imposing fiscal discipline (encouraging them to make smarter financial decisions, especially when it comes to acquisitions.)
According to S&P, corporations are increasingly choosing stock buybacks over dividend increases as a way to reward shareholders. If this trend continues, investors could see a decrease in companies willing to offer dividends.
Differences Among Dividends
Of course, nothing in life comes with a guarantee, and dividend payments on common stock are no different. A company’s board of directors is at will to decide to reduce or even eliminate them at any time. That being said, a steadily increasing dividend is seen as a reliable barometer of a company’s health and stability. If for no other reason, most corporate boards are reluctant to send negative signals by cutting dividends.
This is not an issue for investors who hold preferred stocks, which boast a fixed rate of return paid out as dividends. There is a trade-off to the guarantee of a fixed rate, as preferred shareholders do not share in a company’s growth in the same way as common shareholders – so if a company does well and increases its dividend, preferred stockholders will receive the same payments.
There are several ways in which preferred stocks earn their designation. For one thing, dividends on preferred stocks are paid before common stockholders can be paid a dividend. Most preferred stockholders have no voting rights in a company, but if the company experiences financial difficulties their claims on assets will be satisfied before those of common stockholders. Also, as a rule, preferred shares pay a higher rate of income than common shares.
Preferred stocks behave somewhat like bonds, by virtue of their fixed dividends. For example, their market value can be affected by changing interest rates. Much like a callable bond, most preferred stocks have a provision allowing a company to call in its preferred shares at a set time or at a predetermined future date.
The Importance of Being Informed
It goes without saying that when it comes to investing, the more prepared you are, the better. Picking the right stock is not as simple as merely picking the one with the highest yield. You should consider whether the company's cash flow can sustain its dividend, if you are investing for income.
Some companies exercise their right to buy back company shares with corporate profits, which can increase the value of existing shares. It can also take the place of instituting or raising dividends.
If your investing style is focused on dividends, you should be on the lookout for terms such as “dividend income”, “equity income” and “growth and income.” Also know that some exchange-traded funds (ETFs) track an index made up of dividend-paying stocks, or which is based on dividend yield. Make sure you read the prospectus to learn about expenses, fees and potential risks and consider everything carefully before you invest.
Taxes and Dividends
Some dividends, including the ones paid by real estate investment trusts (REITs) and master limited partnerships, do not qualify for the 15% maximum tax rate and a portion may be taxed as ordinary income. Also keep in mind the 15% maximum rate is once again scheduled to expire at the end of 2012, and there is no guarantee dividends will continue to receive favorable treatment from the IRS.
The 15% rate applies to qualified dividends, those which come from a U.S. or qualified foreign corporation and one which you have held for more than 60 days during a 121-day period – 60 days before and 61 days after the stock's ex-dividend date. Form 1099-DIV, which reports your annual dividend and interest income for tax accounting purposes, will let you know if a dividend is qualified or not.
You should also keep in mind that, for tax purposes, some so-called dividends are actually considered interest. These include (but are not limited to) dividends from deposits or share accounts at cooperative banks, credit unions, U.S. savings and loans or building and loan associations, federal savings and loan associations and mutual savings banks.