You might choose to invest your money for a lot of reasons. Maybe you want to try day trading, moving money in and out of stocks based on financial and business news.
Or you may want to buy and hold investments, hoping for long-term growth that will help you build a nest egg for retirement.
Another reason to invest is to produce a stream of income. If you have enough money in the market, you can produce enough income to supplement your job or even replace your job entirely.
You get this income in the form of dividends. Dividends are cash payments that companies make to their shareholders.
Even if you don’t plan to spend the money you receive from dividends, you can reinvest that cash and use it to build your nest egg. That makes dividend investing a popular strategy for many people.
What is a Dividend?
A dividend is a cash payment that companies pay to their shareholders. It’s a way that businesses return extra profits to their owners.
When you own a share of a business, you’re a partial owner of that company. It makes sense that a business owner would take some money out of the business if it does well, and dividends are how large companies pay their owners.
Typically, a company declares its dividend in advance of the actual payment. The announcement includes the amount of the dividend, the date on which you must own a share to receive the payment and the date the company will make the payment.
On the payment date, the company sends the dividend to each shareholder based on the number of shares they own. For example, if company XYZ declared a $1 dividend and you own 100 shares, you’ll get $100 on the dividend payment date.
You can set up your brokerage account to automatically reinvest your dividends, using the money to purchase additional shares of the business. You can also tell your brokerage to keep the dividends in cash so you can use them for other purposes.
Typically, businesses pay dividends once per quarter, so you’ll receive four payments from your dividend-paying stocks each year.
For companies that pay dividends, the consistency of their payment is critical. Most aim to keep their dividends the same or increase them year after year. Reducing the dividend payment or skipping payments entirely can lead investors to lose confidence in the company and hurt its share price.
Some investors flock to companies called the Dividend Aristocrats, large companies with a twenty-five-year track record of increasing their dividends.
Why do companies pay dividends?
Not every company pays dividends to its shareholders. Some businesses choose to retain their earnings and use the money for other purposes. In fact, there are many situations where investors don’t want a company to pay dividends.
Generally, the companies that pay dividends are large, well-established and slower growing. Dividends return some of the business’s earnings to shareholders because the business doesn’t need all of the extra income to continue its growth.
Paying the shareholders instead of investing the profits in additional growth ultimately provides more value to the company’s owners.
Contrast this with a startup business or fast-growing tech company. People invest in these types of businesses because they want to see explosive growth.
If a startup decides the best thing it can do with its earnings is to pay them out to shareholders, it’s a sign that the company’s leadership doesn’t see major growth potential.
A successful startup would be able to use that cash to grow its business, ultimately increasing its share price and offering more value to shareholders.
One great example of reinvesting in the company instead of paying shareholders is Apple. Apple formed in 1976 but did not start paying a dividend until 2012, at which point it was a major, established tech company.
How to Earn Dividend Income
You can earn dividends through Dividend investing which is a strategy that focuses on purchasing shares in businesses that pay a dividend, using those dividends to create a stream of remaining income.
You can use the income that you receive to reinvest in the company, purchasing more shares. On the other hand, you can use your dividend income to pay your living expenses or invest in other opportunities.
Dividend investors often focus on large, stable businesses that have built a track record of consistently increasing their dividends. The Dividend Aristocrats are a popular choice for many dividend investors.
While dividend investing offers a source of passive income, it does have some risks. Dividends aren’t a sure thing. The company can choose to cut or cancel its dividend at any time.
Large companies with steady dividends might also offer less price appreciation than other stocks, meaning your investments may gain value more slowly than others.
Related article: 10 Best Dividend Trackers
What is Dividend Yield?
The dividend yield is a popular measure of the dividend that a company pays. To calculate a company’s dividend yield, divide their annual dividend payments by their stock’s current price.
For example, if company XYZ pays $1 in dividends each year and has a share price of $50, its dividend yield is 2%.
Because stock prices change constantly, dividend yields also change all the time.
Many investors look for dividend yield when choosing their investments. If your primary investing goal is to produce a stream of dividend income, investing in stocks with higher dividend yields will increase your earnings.
However, remember that bigger dividend yield isn’t always better. If a company’s dividend payments are too large to be sustainable, it might have to cut its payments or stop them entirely. Incredibly high yields can be a sign of trouble for a business.
What is Dividend Income?
Dividend income is the money that you receive from the dividends paid by stocks that you own. Whenever a business pays a dividend, and you receive the payment, that is dividend income.
What are the advantages of dividend income?
There are several advantages to receiving dividend income.
One is, simply, that you’re receiving income. There are very few people in the world who would refuse money if someone offered it to them with no strings attached. A dividend is a lot like that. A company offers to give you money just because you own shares in it.
Another benefit of dividend income is that it’s passive income. Once you buy shares, you don’t have to do anything to earn the dividend. Just wait for the dividend payment date and let the cash arrive in your brokerage account.
Dividend income also tends to be consistent and grow over time. Steady dividends that increase in size over time are vital to established businesses.
Cutting or skipping dividend payments is a sign of weakness and can hurt a company’s share price. Businesses that commit to dividend payments work hard to keep the money flowing.
Even as you receive your dividend income, the businesses that you own shares in may continue to grow. That means that your shares could increase in value in addition to the income that you receive. This potential offers additional opportunities to grow your savings.
Finally, dividends receive preferential tax treatment compared to regular income. Two people who each earned $50,000 last year, one who made their money from working and one from dividends, will pay very different amounts of tax.
Depending on your income, the IRS taxes qualified dividends at the capital gains tax rate. That means you’ll pay 0%, 15%, or 20% tax on the income. This is much lower than the tax rate for regular income, which maxes out as high as 37%.
Some unqualified dividends are taxed at your regular tax rate. Still, most of your dividends will be qualified if you’re a buy and hold investor, like most people who follow dividend investing strategies.
Should you choose a dividend-focused investing strategy?
Whether a dividend-focused investing strategy is right for you depends on your goals and financial situation.
Dividend investing is popular among people who are nearing retirement. People perceive large, stable companies that pay dividends as less prone to market volatility than smaller companies. Moving your money into these businesses could help you avoid significant losses in your portfolio.
Dividend investing also lets you create a stream of income that you can use to cover your expenses during retirement. If you spend $36,000 per month, receiving $10,000 per year in dividends means you only need to come up with $26,000 from other sources, like Social Security.
If you’re younger or more willing to accept volatility in search of investment gains, dividend investing might not be the right strategy. Instead of focusing on established businesses, you can invest in smaller companies with greater growth potential.
Index investing isn’t entirely contrary to dividend-focused investing strategies but is another viable alternative. You may choose to invest in an index fund, such as a total market fund or a fund that focuses on a group of stocks like the S&P 500.
Yet, in doing so, your goal is to match the performance of the market. That means owning shares in businesses, whether they pay dividends or not.
Index investing lets you diversify your investment and helps you reduce your risk, which is one of the goals in dividend investing. If you prefer greater diversification rather than focusing on dividend-paying companies, index investing might be a better strategy for you.
Dividends are one way that businesses return money to their shareholders. Dividend income has a lot of advantages beyond the fact that it is passive income.
For example, dividend investors pay less tax on their dividends than workers pay on their income. Also, dividends can create a reliable source of income for people nearing retirement.