In today’s world, everyone is looking for ways to create additional income streams whether it be through passive income, side hustles, or jumping in on the latest crypto craze. If you have explored stocks for any amount of time you have most likely stumbled upon the term “dividends” and wondered if this could be a way to create passive income. The short answer is definitely maybe! Dividends can be a great way to create passive income, however, it’s important to understand what it is and how it plays into your overall investment strategy.
So what exactly is a dividend?
Put simply, a dividend is a payment a company makes to all owners of its stock. The idea is that the company takes the extra profit that it makes and distributes those profits to the shareholders. It’s important to note that not all stocks pay dividends and just because a stock pays a dividend today doesn’t mean it is guaranteed to pay that dividend again. Stocks that pay dividends will typically pay them quarterly, however, some stocks will pay monthly dividends. If a stock pays a dividend, it will typically pay out a specific amount for every share you own. If a stock pays $1 per share and you own 100 shares, they will pay you $100. Before you go and start dumping your life savings into dividend stocks, let’s take a closer look at some very important details.
How do I know if a company pays a dividend?
Most companies who pay dividends will list it whenever you research the companies ticker symbol. It is important to keep in mind that just because a company has paid a dividend in the past doesn’t mean it is obligated to do so in the future. It is also important to note that the dividend can change. Most companies have a board of directors who must vote on whether to pay a dividend and how much it will be. A company may have paid out a dividend for several years, however, if profits drop, the dividend may be reduced, suspended, or eliminated entirely. When researching a companies dividend history, its important to see how consistent it has been and whether it has increased each year. There are a few companies called “Dividend Aristocrats” who have paid out consistent dividends that have increased every year for at least 25 years. These companies have shown that they can continue to pay out and increase their dividends even in poor economic times so are most likely to continue to do so. Keep in mind that just because a company is a Dividend Aristocrat doesn’t mean they won’t cut their payouts. In 2023, VFC cut its dividend for the first time in 50 years, removing itself from the Dividend Aristocrat list.1
How do I make sure I get this payment?
Whenever a company decides to pay a dividend, it must decide an ex-dividend date and payment date. You must own the stock at least 1 day before the ex-dividend date to qualify for the dividend payout. You must also elect what you want done with the payment (you can typically choose to either receive the dividend as cash or reinvest it in the same stock). Dividends are considered taxable, so it’s important to consider the tax implications. Unqualified dividends will be taxed as ordinary income, whereas qualified dividends will have preferential tax treatment. Several factors determine which one your dividend falls into including how long you have owned the stock (most stocks require you hold it for at least 60 days prior to the ex-dividend date to be a qualified dividend payment2). You are still liable for the taxes on dividends even if you reinvest it instead of taking it as a cash payment.
Investment strategies
What would stop you from buying a stock the day before the ex-dividend date and selling it a couple of days later just to get the dividend payment? The short answer is nothing. Some people do this strategy and sometimes it works, sometimes it doesn’t. Just like any investment strategy, there is risk. Typically, a stock will increase in value right before its ex-dividend date (usually because more people are trying to buy it before this date to qualify for the dividend) and drop following the ex-dividend date (more people selling it since they are already getting the dividend payment). I would encourage you to watch a few stocks the week of their ex-dividend date. Sometimes the price goes up and sometimes it goes down. This is a risky strategy because a dividend is usually a very small percentage of the price of the stock so if the stock drops too much you will lose more than you get from the dividend.
Is there a better way to invest in dividend stocks?
If you want to purchase a stock that pays dividends and you are willing to hold it for a long period of time (2 years or longer), here are a few things to look for: 1st you want to consider the yield of the dividend (how much the company is paying you vs. the price of the stock). A higher yield isn’t always a good thing (a company that pays a huge dividend yield is unlikely to be able to keep that up long-term). You want to ensure the yield is attractive but realistic enough that the company can pay it consistently. It’s also important to look at their track record to see how likely they are to continue that payment. It’s also important to consider the long-term profitability of the company. There are a lot of companies that pay a dividend but have little upward potential for the future. This isn’t necessarily a bad thing, but you shouldn’t expect the value of your stock to rise quickly. Ideally, you would find a stock that is likely to increase in price while paying out a dividend. Once you have picked the perfect stock, it’s important to invest in an account that will give you preferential tax treatment. A Roth IRA would be a great account to invest in as you won’t be taxed on your dividends and if you follow the rules, you won’t be taxed once you are able to make withdrawals from that account as well. If you set your dividends to reinvest as well, you could start to see your account grow substantially over the years due to compound interest (If you own 100 shares of stock that pay $1 dividend you will receive $100 each payout. If that money goes to purchase more shares, then the next payout you may own 102 shares which increases the next dividend payment you would receive. Do that 4 times a year for a few years and you could see how that could increase exponentially).
There are other ways to invest in dividend stocks. There are several ETFs that seek to match the investment of specific dividend-paying stocks. One popular ETF with the ticker symbol NOBL tracks the “Dividend Aristocrats” stocks. Another popular ETF with the ticker symbol USA seeks to track popular tech stocks and aims to pay out a 10% dividend yield per year. While these funds pay out dividends, they have been outperformed by several stocks and ETFs that do not pay out dividends. It is important to do your homework and pick a stock or ETF that meets your investment strategy. A good portfolio should contain some mixture of dividend-paying stocks or ETFs, just know that they are subject to the same ups and downs as any other stocks with the same opportunities to lose money or make money.
Sources
2. https://turbotax.intuit.com/tax-tips/investments-and-taxes/guide-to-taxes-on-dividends/L1jBC5OvB
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