Dividends. What are they and why do they matter to you?
To try and avoid paying the tax man, corporations issue dividends to their shareholders as a means of reducing their reported earnings. It is also how corporations repay investors and give them a return for having provided the needed capital. Of course a company needs to be profitable before it can give out dividends to investors; otherwise it is just increasing its losses. So, a company that gives out dividends is usually a sign that the company is doing and will continue to do well in the future. When looking into stocks, this is something to consider as this is a quick way to find companies that are profitable.
For the average investor, the benefits to receiving dividends are easily apparent. First, companies are essentially paying you for owning shares of their stock. It might only be $0.10 per share per quarter, but with 100 shares, that’s $10 a quarter and $40 a year. With more shares and higher dividend payouts, one could be making a significant sum on just dividend payments. If the company’s share price stays flat, then you’ve still made at least a small return on your investment. Since dividend paying companies are usually very profitable, dividends are more like the cherry on top of a sundae in terms of your investment income. That is to say, you shouldn’t focus on dividends but see them as an additional (some might say essential) part of your total investing strategy.
The second benefit of dividends is the tax-rate at which you receive them. Most dividends paid out by companies are qualified dividends. Qualified dividends are taxed at the long-term capital gains tax-rate instead of as ordinary income tax-rates. This is usually at 15% for most people instead of an average 25-to-35% income tax-rate. In a long-term buy-and-hold strategy, accumulating a large and diverse portfolio of stocks that pay dividends will allow one to retire with a steady stream of income at a lower tax-rate. Just be aware that non-qualified dividends will be taxed at your current income tax-rate along with your ordinary income.