Whether you are a seasoned investor or still reading investing for dummies, we’ve all heard about dividends.
Some people will tout that they only invest in dividend stocks or funds, others will tell you you should wait until retirement, so which is it. Like anything else in investing, the answer is…it depends. Before going into different advantages and disadvantages of dividends let’s review.
What Are Dividends in the First Place?
When companies turn a profit they have a few options as to what to do with that profit. One of those options is dividends. Dividends are sums of money that a company (or mutual fund) will payout to its shareholders from its profits on some sort of regular basis. Typically, they are paid out quarterly, but some will do it monthly, or even annually. Investors can decide if they want to keep their payouts or reinvest their money by buying more shares of stock in the same company.
- How to Sign Up for a Fidelity Brokerage Account
- How to Buy a Stock at Fidelity
- How to Create a Monthly Dividend Portfolio
Types of Dividends
Dividends are typically paid to any shareholders with common stock and there are several types of dividends a company can choose to pay out to its shareholders.
- Cash dividends – This is the most common type of dividend. As the name suggests, it’s cash paid directly to the shareholders..
- Stock dividends – Instead of cash, companies will pay investors with shares of stock.
- Dividend Reinvestment Programs (DRIPs) – DRIPs allow investors to reinvest their payouts into owning more shares of stock. Sometimes companies will offer discounted prices when using a DRIP.
- Special dividends. Typically, dividends are paid out on a regular schedule. When a company decides to pay dividends that are outside that schedule for whatever reason, they are considered to be Special dividends.
- Preferred dividends. A preferred dividend is a dividend that is allocated to and paid on a company’s preferred shares. Preferred shareholders will have their dividends paid first in case a company cannot pay all shareholders.
Why Companies Pay Dividends
Seeing that dividends come from a company’s profits, one might wonder why they would want to pay dividends in the first place. Typically, the reasoning behind paying dividends is to show investors that the company is a safe and secure investment. By doing so, the hopes are to attract more investors which in turn will raise the stock’s price. When a stock’s price rises, those owning stock, especially those employees with a lot of shares, stand to make even more money.
Why Companies Don’t Pay Dividends
On the flip side, many companies will choose not to pay out dividends, this again can be for many reasons. For one, not all companies turn a profit and without a profit, there are no dividends. A newer or smaller company may need to use their profits for other things, such as paying off debts, research, or even expanding the business.
Why You Should Invest In Dividend Paying Stocks or Funds
When deciding what to invest in, there are several reasons why you should look into investing in a dividend-paying stock or mutual fund.
The Stock is More Stable
Typically, when a company is paying out dividends, it’s confident in its ability to continue to make money. More often than not, the companies paying out dividends are more established and less likely to disappear overnight. These stock prices can be much more stable and investors can have more confidence the company will be around even in bad times.
One of the biggest uses for dividends is to provide a secondary or even primary source of income. With enough invested, you could see thousands of dollars in dividends a quarter. Dividend income is typically seen as a supplement for upcoming or recent retirees, but there are many younger investors who are building dividend portfolios that allow them to retire early.
Taxed Less Than Ordinary Income
Part of the draw of using dividends as income is that they are taxed at a lower rate than ordinary income. The tax rate on qualified dividends is 0%, 15%, or 20%, depending on your taxable income and filing status, which can be much lower than your regular tax rate.
They Can Go Up
Dividend payouts can fluctuate, in order to draw more investors, most companies will attempt to raise how much is paid out to shareholders. The amount paid is typically done per share. If a company has seen a steady increase in profits, it may decide to pay a portion of these increased profits to its shareholders.
Why You Shouldn’t Invest In Dividend Paying Stocks or Funds
Dividends sound all good right, free money just for owning some stock right? For as good as dividends might seem, there are some considerations to think about before overloading your portfolio with dividends stocks or mutual funds.
Less Tax is Still Tax
I mentioned before that advantage of dividends is that they are taxed lower than ordinary income, but in the end, they are still taxed. When you invest in growth stocks, you’re not taxed on any of the capital gains until you actually sell. Hopefully, when you do sell, you’re able to do so when keeping yourself in a lower tax bracket. When receiving dividends now while you’re still earning other income, it’s possible you’d be taxed more. In either case, come tax time, you might have a hefty bill than you’d like with too much dividend income, especially if you choose to reinvest them.
They Can Go Down Too
Just as dividends going up can be an advantage, they can also be decreased as well. Although many of the companies offering dividends are relatively stable, it doesn’t mean profits go up forever. Dividends can remain flat, technically losing you money due to inflation, or even be decreased. Because they are somewhat unpredictable, using them as a main source of income needs to be done with proper planning.
You’ll Earn Less Than Growth Stocks
Historically speaking, stocks will gain 7% in value year over year on average. Yes, there are down years and years they gain much more, but 7% is typically seen as the expected return. Finding a stock that offers a 7% dividend is almost unheard of. Meaning, that if you put more into growth stocks and transition to dividends later in life, you’ll end up with more earnings in the long run.
They Hurt The Stock Price
With the last section in mind, if growth is what you are looking for, then steer clear of dividend stocks. You can’t have your cake and eat it too in this case. When companies offer dividends, it comes out of their own pockets. If you have two identical companies, but one offers dividends, they now have less cash than the other and are therefore worthless. That difference in total worth is reflected in the stock price.
When Should You Invest In Dividends
Look, there is no magical time when it is best to invest or not best to invest in dividends stocks, mutual funds, or ETFs. When investing in dividends, make sure you know all the pros and cons. Make sure whatever you are investing in fits your goals, not just for today, but for 5, 10, or 20 years down the road. Many people will do a combination of dividends paying and non-dividend paying investing, but it’s up to you to figure out what the best ratio is for you.
Jeff is a fan of all things finance. When he’s not out there changing the world with his blog, you can find him on a run, a Mets game, playing video games, or just playing around with his kids.