Dividend investing

In short

A friend of mine once bragged that his stock sent him a check every three months, and he looked as pleased as a man who had found money in an old coat. If you own shares that pay dividends, you are getting a small slice of company profit in cash. A dividend is a choice the company makes, and it can be cut at any time. Check how your account treats each payment, because a dividend in a taxable account can create a tax bill in the year you get it. Read the yield and the payout ratio together, and never read the yield alone. Decide whether you want the cash to spend or to reinvest, since the answer changes which account fits you. Look up the current tax rates on the IRS site before you count on any number.

The whole of it

What it is

I once watched a neighbor tend a small orchard, and he told me the apples were nice but the real point was the trees. Dividend investing works something like that. You buy shares of companies that share part of their profit with owners, and the payment arrives as cash.

A dividend is a payment from a company to the people who own its stock. The board of directors decides whether to pay one, how much, and when. Nothing forces them to keep paying. If profits fall, the payment can shrink or stop.

You have probably heard the word yield. Yield is the yearly dividend divided by the share price, shown as a percent. If a share costs 50 dollars and pays 2 dollars a year, the yield is 4 percent. The yield moves when the price moves, even if the dividend stays put.

Some people build a plan around this cash. Some like the steady feel of it. Others just like getting paid to wait. There is no wrong reason, but it helps to know your own.

How it works

A woman I know kept a paper calendar on her kitchen wall, and she circled the days her dividends landed. Those days have names, and the names matter.

The declaration date is when the company announces the payment. The ex dividend date is the cutoff. If you own the shares before that day, you get the payment. If you buy on or after it, the seller gets it instead. The payment date is when the cash shows up in your account.

On the ex dividend date, the share price usually drops by about the size of the dividend. That is fair, because the cash has left the company. So a dividend is not free money on top of the share. It is a piece of the company handed to you in a different form.

You can take the cash or reinvest it. A plan that reinvests dividends buys more shares with each payment, often including small pieces of a share. Over many years, that can grow your holdings without new deposits from you. It also means you own more of a company you already own, so watch your balance.

You can also own dividend funds, which hold many dividend paying stocks at once. The fund collects the payments and passes them along to you. That spreads the risk of any one company cutting its payment. Funds have costs, though, so look at the expense ratio, which is the yearly fee shown as a percent of your money.

The numbers, and where to find yours

If you are holding dividend stocks, you will want three numbers. The first is the yield, which your broker shows on each stock page. The second is the payout ratio, which is the dividend divided by the company's earnings per share. A high ratio means the company hands out most of what it earns, and that leaves little cushion. The third is how long the company has kept paying or raising its dividend.

Taxes come next, and they depend on your situation. Dividends split into two kinds for tax purposes. Qualified dividends are taxed at lower long term rates. Ordinary dividends are taxed like regular income. The qualified rates are the current figure, which the official source publishes each year, and the income levels where each rate applies are the current figure, which the official source publishes each year. Higher earners may also owe an added tax on investment income, and that rate is the current figure, which the official source publishes each year above a threshold of the current figure, which the official source publishes each year.

Your broker sends a Form 1099 DIV after the year ends. It lists what you were paid and how much was qualified. You can read the rules yourself in IRS Publication 550, called Investment Income and Expenses, and in the Form 1040 instructions. Both are on irs.gov. Dividends held in a Roth IRA or a traditional IRA follow different rules, since those accounts change when and whether tax is due.

A worked example

Let me tell you about a man I will call Daniel. He is 45, and he put 20,000 dollars into a fund that pays a 3 percent yield. He wanted to see what the cash would look like, so he did the sums with a pencil.

His yearly dividend is 20,000 dollars times 0.03. That equals 600 dollars a year. Split across four payments, each check is 150 dollars.

Daniel holds the fund in a taxable account, so he asked what the tax might be. Suppose all 600 dollars is qualified and his rate is 15 percent. That is a made up rate for this story, not the current one. So the tax is 600 dollars times 0.15, which equals 90 dollars. After tax, he keeps 510 dollars.

Now he reinvests. In the first year, he has 20,000 dollars in shares plus 510 dollars from the after tax dividend, so 20,510 dollars. Suppose the share price stays flat for simplicity, and the yield stays at 3 percent. Next year the dividend is 20,510 dollars times 0.03, which equals 615.30 dollars. That is a bit more than the year before.

Small change, you might say. It is. The gain shows up slowly, over many years, and the tax bill rides along the whole time. Daniel decided that this pace suited him, because he liked the calm of it.

Where it goes wrong

I once knew a fellow who chased the highest yield he could find, and he thought he had struck gold. A very high yield often means the share price has fallen hard. The market may be telling you the dividend is in danger. A cut then follows, and he lost twice, once on the payment and once on the price.

Another trouble is putting too many eggs in one basket. Dividend stocks often cluster in a few kinds of business. If those businesses struggle together, your income and your savings both feel it. Spreading out helps.

Taxes can bite quietly. In a taxable account, you owe on dividends even if you reinvest every cent. You never touched the cash, yet the bill still comes. Plan for it.

Timing tricks catch people too. Buying just to grab a dividend does not work, since the price falls by about that amount on the ex dividend date. And a payment you like the look of is not a promise. Companies cut dividends in hard years.

Last, a dividend is only one part of what you earn. The share price can rise or fall. Your total result is the payments plus the price change. Looking at only half of it gives you half a picture.

Questions to answer before you leave this page

Do you want cash to spend now, or do you want your money growing in the background, and which of those would let you sleep better? Which account holds your dividend stocks, and do you know how that account is taxed? Have you looked at the payout ratio for each company you own, and does it leave room for a hard year? Are you leaning too hard on one kind of business? Have you checked the current rates and limits on the IRS site, and read your Form 1099 DIV when it arrived?