3 Things to Know Before Buying Dividend Stocks

Dividend investing is a popular way to create passive income, but before you start building your own dividend-generating portfolio, there are a couple things you should be aware of.

What are Dividends?

A dividend is a distribution of part of a company’s earnings to its shareholders. Dividends are typically paid on a quarterly basis, but can also be offered monthly, annually, or any other time the company decides to issue one. The payment is based on a certain dollar amount offered per share.

What to Watch Out For

Below we’ll cover 3 of the most common misconceptions or pitfalls of investing in dividends, and what you want to look out for.

Dividends Aren’t Extra Returns

When a dividend is paid out, no money is actually gained or lost. I’ll explain…

Typically, when buying a stock, we’re hoping it has increased in price when we go to sell it later. Dividends are enticing because you can get some of your returns having to sell any shares. That’s awesome, but it’s important to understand this is not some sort of extra money or additional return.

In fact, on the stock’s ex-dividend date, the price and value of the stock will decrease by the amount of the dividend. The amount is usually small enough that it’s not very noticeable, and the price of the stock will continue to go up and down as trading continues.

Below is a much more obvious example that illustrates this phenomenon. In December 2012, Costco announced a special, one-time $7/share dividend. You can see in the chart below that on the ex-dividend date, the price of one share of Costco stock dropped from $105 to $98.

This is simply to keep things balanced. For example, say a company that was valued at $100 had a single share of stock. The price of that share of stock should be $100. If they pay a $10 dividend, that cash leaves the company and the company is now only worth $90. Essentially a portion of your ownership in the company, represented by the shares you own, gets transferred into cash. In this example, you have $100 in value both before and after the dividend. Before all $100 was in stock. Now you have $90 in stock and $10 in cash.

This isn’t a bad thing. In fact, it’s a convenient way to receive income from your investments without having to make any trades. However, it’s important to understand that no money is gained or lost. It’s simply a transformation of a portion of your ownership in the company into cash.

Dividend Payouts Can Vary

When investing to earn dividends, also keep in mind that dividend payouts can vary on a regular basis. A company can even cancel their dividend altogether.

Typically, a company will declare a dividend alongside their quarterly earnings report (if they plan to offer one). As such, it is heavily dependent on the recent performance of the business. The ideal, of course, is that the company continues to grow its business and make more money. This way they can pay out a dividend consistently, and even increase future payouts.

When determining if a company will provide consistent dividend income, you want to look at how long the company has paid a dividend and how the amount of the dividend has changed over time. It’s pretty easy to pull this up online. You can look at the company’s past financial reports, or lookup the ticker symbol on something like nasdaq.com.

Double Taxation

One of the drawbacks to dividends is double taxation.

First, the company pays taxes on its earnings, and shareholders of the company are effectively the ones paying this tax. Then, when shareholders receive their dividends, they have to pay taxes again. This is usually more of a concern for shareholders that have large stakes in the company because it brings up the question of if that’s the most effective use of the business’s capital. For everyday people, it’s may not even be noticeable.

There is a silver lining though! Qualified dividends are taxed at the same rates as capital gains, which are much lower than the tax rates applied to your W-2 income. Note: a “qualified” dividend typically requires that you’ve held the stock for at least 60 days.

From NerdWallet

Overall, dividends are an effective way to create passive income from your investment portfolio, and it’s pretty awesome that qualified dividends are taxed at a lower rate than typical income. However, keep in mind that the company can change its dividend payout at any time and dividends are not some sort of extra return.

If you’re a beginner investor and looking to get started, check out my other blog post for new investors!

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