Introduction to Dividends

(I know I’m publishing this on Saturday, not Friday. It was set to post on Friday, but then evil computer gremlins attacked. It’s a little late and I apologize for that. Hopefully you will learn something new and that will make up for the delay)

With some stocks, you pay a price now to purchase the stock, then when you sell you get money back. Hopefully more than you paid to purchase the stock in the first place! There are two exchanges of money: time of purchase, and time of sale. But with some stocks, you can receive money on a regular basis. The company will pay you a small amount, usually on a quarterly schedule. This is called a dividend. An annualized dividend is the the total annual amount per share.

Basically, a dividend is when a company decides to pay shareholders a portion of the company’s earnings. The payment is often made in cash, but could also be paid with additional shares or other means. As the shareholder, a dividend is your portion of the company’s earnings. It is generally the only way most investors will earn money from a stock without selling.

That sounds awesome! Why don’t all stocks offer Dividends?

Instead of paying out dividends, a company can choose to reinvest the money in the company. If done successfully, that will increase the company’s overall value and, thus, the price of the stock. That (hopefully) means the stock will have greater gains than a dividend stock.

You know how you always hear about that friend of your brother who made $10,000 in a week by buying a stock and then selling it when the price went up? That (fictional) guy didn’t make money from dividends. He made it from the stock’s gains. This is something you are more likely to see with newer companies, when they are doing a lot of reinvestment. If the company is fulfilling a new need, or hasn’t yet reached all possible customers, it still has a lot of growth it can achieve. So those companies will reinvest earnings in hopes that the value of the company will rise, and therefore the stock price will rise.

Okay. So what kinds of stocks do offer Dividends?

Generally speaking, dividend stocks are going to be your behemoth companies – Proctor and Gamble, Coca-Cola, General Motors. The kinds of companies you grew up with. That’s because they’ve been around for so long that they have already reached most potential customers, and the stock price isn’t likely to grow very fast. So they offer dividends to keep the interest (and money) of investors. They will still reinvest money, but their earnings are more stable than a new company so they can offer a dividend knowing pretty well whether they will be able to pay it out successfully.

How much is a Dividend worth?

It’s really up to the company to decide how much they will pay out. Plus, of course, it will depend at least in part on how much the company earned recently. But here is a list of some dividends and dividend yields from some recognizable companies. These numbers are current as of May 27th, 2017:

• General Motors (GM): $1.52 annualized dividend, 4.58% yield
• Coca-Cola (KO): $1.48 annualized dividend, 3.29% yield
• General Electric (GE): $0.96 annualized dividend, 3.45% yield
• Wells Fargo (WFC): $1.52 annualized dividend, 2.86% yield
• Apple (AAPL): $2.52 annualized dividend, 1.64% yield
• AT&T (T): $1.96 annualized dividend, 5.14% yield

***I am not recommending you buy any of these stocks. In fact, the instances in which I would recommend anybody buy any individual stocks is rare. These are just examples***

How much money does that equal?

To figure out how much money to expect each year, you need to know your number of shares and the annualized dividend. If you have 20 shares of a stock and the annualized dividend is $1, you would get $20 per year.

Finding the annualized dividend should be easy. Just type in the company name and “dividend” into Google and you should be able to find it. If you can’t find the annualized dividend, you can take the current share price and multiply by the current yield to get the annualized dividend. So if you have 20 shares of a stock, the stock price is $50/share, and the dividend yield is 2%, your annualized dividend (per share) is $1 and your total annual payout would be $20.

You might be wondering how that is supposed to turn into a livable income. Well, it’s going to take time. You might only be able to buy 200 shares this year. But after 30 or 40 years of doing that, you might have (for instance) 8,000 shares, each paying $3 per year. Boom! All of a sudden you have $24,000 per year in income. That’s not a ton of money, I get it, but remember that you also still have the 8,000 shares. You can sell them to make more money.

For instance, let’s say you’ve achieved $24,000 in annual dividend income (awesome!). Let’s say you also have 8,000 shares of a stock trading at $50/share. A Safe Withdrawal Rate for someone in their mid 60s is 4%. Four percent of 8,000 shares is 320 shares. If you sell 320 shares each year, you increase your annual income by $16,000 (320 * $50 = $16,000). All of a sudden you have $40,000 in annual income ($24,000 + $16,000). Not bad! Just keep in mind that as you sell shares, you would have less dividend income in the future because your dividend income is based on how many shares you have.

Selling your shares in colloquially known as “touching your principal.” If you can manage to live just off your dividends and other income (pensions, rental income, etc) without touching your principal then you are in a pretty amazing spot financially. But the reality is that most people will have to sell some of their principal to fund their retirement. So Plan A should be to fund your retirement without touching your principal. But if you have to move to Plan B by selling stocks, don’t stress it too much. Most people do.

What are the tax implications of Dividends?

Dividends are income, and you will receive a 1099-DIV tax form from any company that pays you more than $10 in dividends each year. Keep in mind you are responsible for reporting your dividend income even if you don’t receive the form. There are two types of dividends listed on the 1099-DIV: ordinary dividends and qualified dividends.

Ordinary dividends are paid out of a company’s earning and profits, and are taxed as ordinary income. So if you have $1000 in ordinary dividends and you are in the 25% tax rate bracket, you will pay $250 in taxes for your ordinary dividends.

However, if you receive qualified dividends you might be able to save some of that tax money. Qualified dividends are ordinary dividend to which capital gains tax rates apply. Since capital gains tax rates are usually lower than income tax rates (they are currently a max of 15%), you can pay a little less in taxes with qualified dividends.

A qualified dividend is one that:

• Is paid from a domestic (US) company or a qualifying foreign company and
• Is not listed with the IRS as a dividend that does not qualify or has met the required dividend holding period

Make sure you are accounting for your dividends as you plan out your tax strategy each year. I didn’t pay enough attention last year, and a good dividend year ended up pushing me into the next tax bracket. Because we have a graduated tax rate system in the United States, my overall taxes were only a little bit higher than they would have been if I’d been paying more attention. Still, it’s something I should have thought through. For 2017, I’ve adjusted other elements of my tax strategy to account for this.

What’s the catch?

There really isn’t a “catch” so long as you realize that dividends aren’t guaranteed. The company can stop paying them at any time. More likely, they will change the amount. So you might purchase a stock when the dividend is $2 annually, but then only receive $1.75 annually if the company decides to reinvest some earnings or if profits are down.

Because dividends can change, you don’t want to rely on dividends to pay every cent of your required expenses. As long as you realize this, you should be okay. Oh, and remember the taxes. Always remember the taxes.

Are Dividend stocks better than non-dividend stocks?

No. They aren’t worse, either. It really depends on your goals.

If you are looking to generate steady income, dividend stocks can be great. You can put together a plan wherein you purchase stocks specifically based on the expected dividend (remember it fluctuates) and generate a reliable income this way. For instance, the annual dividend for AT&T right now is $1.96 per share owned. If you own 100 AT&T shares, you will receive $196 in annual income from AT&T. Do that with a variety of companies and thousands of stocks, and you can (eventually) achieve a livable income.

But you know I’m not going to recommend you buy individual stocks. The good news is, there are index funds for dividend stocks, too. If you are going to buy dividend stocks, this would be my recommendation. You can get broad diversification while still receiving regular income.

What if you don’t need the income now but want it in retirement?

In that case, you can use what’s known as a Dividend Reinvestment Plan, or DRIP. This is what I do, since I have income from work that pays my bills. Basically, a DRIP takes your dividend payout and buys tiny portions of new shares with it. So instead of having 100 shares of the company, maybe you have 130 shares after 10 years, without putting any new money into the investment. It’s a way to increase your portfolio, and your potential earnings, without doing anything. Plus, you will earn dividends on the new shares too, so your money is now earning you more money. Pretty cool, right? I’m a big fan of DRIPs and would recommend that anybody who is interested in building retirement income, but isn’t ready to retire yet, look into them.

 

Gentle reminder: I am not a personal finance professional nor am I a tax professional. You should always do your own research before making changes to your finances and talk to a professional if you need additional help. Please read my full disclaimer here.

Do you invest in dividend stocks? Do you use DRIPs or are you using the dividends for income now?