Investors are familiar with stocks and interest, but they might struggle to answer the question “What is dividend income?” One of the nicest things about investing is sharing in the prosperity of a business venture and receiving a portion of the earnings, but without doing any of the work. And that’s exactly what dividend income is.
Think of dividend income as a form of profit from your investments. Dividend income is paid from a company’s earnings directly to its shareholders. It’s like receiving a paycheck from the company in return for buying shares of stock.
Now your dividend paycheck might not be $3.8 billion like Warren Buffett’s expected payout in 2021, but with a little bit of due diligence, you can generate passive income like the pros.
Keep reading to learn more about dividend income, tax treatment, how to determine if dividend income is likely to be sustainable, and how dividend income can help pave the road to a successful retirement.
What Is Dividend Income?
Publicly and privately traded companies rely heavily on their shareholders.
The cash flow and funding from shareholders provides a significant portion of liquidity for the company. Companies are better equipped to pay down debt, reinvest in their business, or even build cash reserves.
In return, when companies earn profits, many of those companies return a small percentage of those earnings to their shareholders in the form of dividends.
You’ll notice mature companies are likely to pay dividends. Because mature companies are established, they require less capital reinvestment. So when they’re profitable, they can more easily afford to pay dividends to investors.
Mutual funds aggregate the stocks of mature companies, so they also typically pay dividends.
How Investors Treat Dividend Income
Typically, dividend income reaches the investor via a check in the mail or a direct deposit to a brokerage account.
The investors can use that cash just like any other income.
Some investors, who don’t need the cash now, opt to reinvest the dividend income and purchase additional shares of the stock.
For example, let’s say you received $1,000 in dividend income from stock XYZ, and the stock price is $10 per share at the time of the dividend payout. If you’re reinvesting your dividends, you would take that $1,000 and purchase 100 additional shares.
Wealth can grow exponentially through reinvestment. Think about it — you now own more shares, so the dividends you receive next time will be larger. And the larger the dividend, the more shares you’ll purchase when you reinvest and so on.
Not to mention that when you reinvest dividend income, you don’t panic when the stock market takes a nosedive.
Why? Because at a lower price, your reinvested dividends actually purchase more shares. And more shares mean larger dividends.
Two Types of Dividend Income
The Internal Revenue Service (IRS) sees the majority of dividend income as taxable income. So taxpayers must understand which type of dividend income they are earning for tax purposes.
There are two types of dividend income: qualified dividends and nonqualified dividends (sometimes called ordinary dividends).
Qualified Dividends
When it comes to tax treatment, qualified dividend income is preferential for the investor. Qualified dividend income is taxed as capital gains, which uses a federal income tax rate lower than the ordinary income tax rate.
The capital gains rate will be either 20%, 15%, or 0%, depending on your tax bracket. Most stock dividends paid in the U.S. qualify for capital gains tax treatment.
In order for dividend income to be considered qualified, the following must be true:
- The organization paying the dividend must be a U.S. corporation or a qualified foreign corporation.
- The investor must hold the underlying stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date.
This can become complicated, which is why the organization paying the dividend indicates whether dividends are qualified on Form 1099-DIV. All dividend stock companies are required to issue these tax forms, so you can relax a bit while preparing your tax return.
Ordinary Dividends
Ordinary, or nonqualified dividends, are those that do not “qualify” or meet the above requirements and are therefore not taxed at the lower capital gains rate. Instead, ordinary dividends are taxed as regular income, using the investor’s ordinary income tax rate on Schedule B.
Understanding Sustainability
Dividend stocks are an important component of many investment portfolios. But before you adopt this strategy, seek to understand the company paying the dividend and whether that dividend income will be sustainable.
Because dividend payments are an indicator of financial stability, investors often assume that all dividend stocks are reliable and safe. After all, the company must be profitable if they have cash left over after operating expenses and putting money back into the business, right?
Not necessarily.
Many companies know how attractive dividends can be to investors. So companies may sometimes pay dividends solely to drive up market value. And if that company pays out too much to stockholders in the form of dividends, the company won’t be able to grow its dividend payment or the business.
That’s why it’s so important for investors to understand if the dividends they see are sustainable.
Indicators of Sustainable Dividend Income
Unfortunately, analyzing dividend income isn’t as simple as comparing Company A who pays 7 cents per share against company B who pays 5 cents per share.
When seeking to understand dividend sustainability, use a more holistic approach. Do your homework about big-picture items, like:
- Company management
- Market volatility in the industry
- The company’s current competitive advantage and overall positioning in the industry
- Current events, market risks, and potential disruptions
When you gain insight into the company, it’s easier to assess whether the company has the ability to maintain current momentum with regard to generating income and paying dividends.
Also, consider a few quantifiable metrics, like:
- Payout ratio: This is the ratio of dividends paid to shareholders in relation to net income generated by the company. Look for ratios that fall between 30% and 55%. Anything higher than 55% is nearly impossible to sustain in the long term.
- Dividend yield: Yield is the ratio of dividend payout per share to stock price per share. An industry standard for a healthy dividend yield is between 2% and 6%.
Dividend Income and Retirement
Many investors hold dividend stocks for the long term and use the payouts in retirement as a source of income.
Because you earn the money without “doing” anything, dividend income is classified as passive income. And having the feeling of financial freedom in retirement is priceless. You have the option of earning dividend income inside a retirement account or inside your brokerage account. Each has its own benefit.
No Age-Related Mandates
Dividend income is especially attractive because dividend stocks on their own have no age-related mandated distributions, like those associated with traditional or Roth IRA accounts.
So, if you invest in dividend stocks in your brokerage account, you can create a stream of income that pays you each month at any point in your life.
Tax-Advantaged
It’s important to note that holding dividend stocks in retirement accounts can help you defer taxes on dividend income or avoid it altogether in some cases.
So, think about holding dividend stocks or mutual funds in a tax-advantaged retirement account, like an IRA.
Time to Get Started
Dividend income, when planned strategically, can pay the bills, generate extra cash for retirement, or enable you to enjoy financial freedom.
You’ve got the basics here in this article for what to look for in stocks that generate dividend income and how to handle tax time. So you can take the next step when you’re ready.
To learn about three dividend stocks that could lay the groundwork for your retirement, subscribe to Investors Alley’s “Dividend Hunter” newsletter.
