Owning Dividend Paying Stocks
Long-term stock market investing helps establish independent wealth. Total returns include capital gains alongside dividends. Capital gains describe price appreciation on shares of stock, while dividends provide regular investment income. Investment decisions related to dividend policy should match your objectives. Stocks that pay dividends are generally more attractive for conservative investors who are in the market for income.
Corporations pay dividends out of their net income. Contrary to legally binding bond interest payments, corporations are under no obligation to make dividend payments. Corporate executives must weigh the advantages of spending cash to pay dividends against reinvesting money back into the business to finance growth.
Retained Earnings vs. Dividends
Small companies within innovative industries, such as, biotechnology and software development pay minimal dividends, if any. These companies have more opportunities for expansion and are therefore more likely to retain the majority of earnings and spend cash on research and development and new equipment, rather than paying out dividends. With this approach, you may benefit from the potential for higher capital gains as a shareholder. Financial risks also increase, because you may lose your entire investment – if a non-dividend paying company were to fail.
Alternatively, large companies within established businesses are likely to make substantial dividend payments. Mature banks, utilities, oil, and tobacco companies are relatively conservative investment sectors that provide fewer opportunities for profit and capital gains growth. Shareholders therefore demand that larger portions of business profits are paid out as dividends.
Qualified Vs. Ordinary Dividends
As a shareholder, dividend payments do carry important tax ramifications. For tax purposes, dividends are categorized as either ordinary or qualified dividends. As of 2010, ordinary dividends are taxed at ordinary income rates, which may be as high as 39.6 percent. Qualified dividends, however, are either tax-free or taxed at maximum 15 percent rates. For qualified dividends, you must own a stock for at least 61 days out of the 120-day period surrounding its ex-dividend date. You buy stock before the ex-dividend date, so that you can receive dividends on the payable date.
With a focus on non-dividend paying companies and capital gains, you may effectively defer paying taxes. For capital gains, taxes are only due when you sell stock at a profit. Long-term capital gains are also either tax-free or taxed at 15 percent. You must hold a stock for more than one year to qualify for long-term capital gains treatment.
Dividend Yields and Financial Distress
En route to bankruptcy, a struggling corporation will cut and eliminate its dividend altogether. Be advised that a high dividend yield may signal looming financial distress. To calculate dividend yield, you divide a corporation’s expected annual dividend payment by its current share price. Therefore, a high dividend yield may actually be the consequence of a weak stock price. A falling share price, flagging sales, and high amounts of debt often foreshadow corporate bankruptcy.
Diversify your stock market portfolio to manage risks. To do so, you put your cash dividends toward the purchase of mutual funds and bonds. If your stocks do not pay dividends, you may sell off part of your existing portfolio and use the proceeds to acquire diversified assets.