Consider Dividend-Paying Stocks
Even though the stock market has recovered from the crash of late 2008-early 2009, many investors are still leery. At the same time, safe alternatives such as bank accounts and Treasury bills have extremely low yields. In this environment, you might consider putting some money into dividend-paying stocks. They provide a relatively low-risk (but not risk-free) way to invest in equities and they can offer significant yields and tax advantages. Consequently, dividend-paying stocks may play a role in a diversified portfolio.
Dividend-paying stocks offer several advantages:
1. Yield. As of this writing, the stocks in the Standard & Poor’s 500 Index have an average yield around 2%. That’s the average; some stocks pay dividends of 3%, 4%, or more. Such yields compare favorably with current payouts from bank accounts, bonds, and money market funds.
2. Growth potential. Companies that pay dividends can increase those payments if their business prospers. A company paying $1 a share in annual dividends, for instance, might pay $1.10 a share next year, $1.20 a share the year after that, and so on. Share prices might rise with a growing dividend.
3. Stability. Companies that pay dividends tend to be well- established enterprises that earn ample amounts of cash. The dividend may act as a cushion in bear markets—investors might refrain from selling stocks that offer cash flow and thus prevent a selling panic. In prior bear markets, dividend payers generally have had smaller losses than stocks that did not pay dividends.
4. Tax advantages. When you put money into a corporate bond or a bank account or a money market fund, the income you earn is taxed at ordinary income rates. Currently, the top tax rate is 35%. Most stock dividends now are taxed no higher than 15%.
Taxpayers who owe 10% or 15% on their ordinary income, owe 0% tax on qualified dividends (see the Trusted Advice column on qualified dividends for further details). In 2011, the 0% rate applies to single taxpayers with taxable income up to $34,500. For married couples filing joint returns, the 0% rate extends to $69,000 of taxable income.
Example: Rick and Madison Peterson have taxable income of $65,000 in 2011, of which $5,000 is qualified dividends. All of their dividend income would be untaxed. If the Petersons have taxable income of $70,000 this year, they would be $1,000 over the $69,000 ceiling. Thus, up to $1,000 of their dividends would be taxed at 15% while any other dividend income would have the 0% tax rate.
The 15% and 0% tax rates on dividend income are in effect for 2011 and 2012. In 2013, dividends are scheduled to be taxed at ordinary income rates up to 39.6%. However, Congress has extended the low tax rates in the past and might do so again. President Obama has proposed making the 0% and 15% tax rates permanent for low-income and moderate-income taxpayers, respectively. Under the president’s proposal, taxpayers with income exceeding approximately $200,000 (single) or $250,000 (joint returns) would owe 20% tax on dividend income—which would be less than the tax rate on investment interest income. Although the future of income tax rates is unknown, it now appears likely that dividends to investors will receive favorable tax treatment.
Recognizing the risks
Investing in dividend-paying stocks can be rewarding but you shouldn’t overlook the risks. Companies that pay dividends can run into trouble and reduce or even eliminate their dividend. Such a cutback might sink the stock price. In addition, dividend- paying stocks are vulnerable to severe bear markets even if the company continues to do well.
What’s more, dividend-paying stocks tend to be concentrated in certain industries, which can add to volatility for investors. A few years ago, for example, banks and other financial firms were among the companies paying sizable dividends. Many of those companies suffered in the crash of 2008–09, so investors lost principal as well as dividend income. Keeping such perils in mind, you should consider diversifying among industries if you’re going to invest in dividend-paying stocks. You also may do well to work with an experienced investment advisor when you select stocks or stock funds.