Dividend Income: It's More Powerful Than You Think

By Selena Maranjian Markets Fool.com

If you're wondering, "What is dividend income?" then here's the short answer: Dividend income is an unexpectedly powerful way to secure a comfortable retirement. Once you read the case for dividends and learn the difference between ordinary and qualified dividends, as well as the tax rates for income from dividends, the next question you'll be asking is "Which stocks pay dividends?"

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Dividend basics

A dividend is a portion of a company's earnings that's paid out to shareholders, typically on a quarterly basis, though some are paid annually, monthly, or even irregularly. When a company earns a profit, it can do many things with that money. It might pay down debt, buy back shares, build new facilities, hire more workers, buy more advertising, acquire another company, and so on. Paying a dividend is just one of many options.

Some companies pay dividends to their shareholders, and some do not. Most often, relatively young and fast-growing companies won't pay dividends, because their best use for excess cash is expanding their business. (That's a way to reward shareholders, too -- making the company more successful and therefore more valuable.) When companies grow larger and have more reliable earnings, then they may choose to pay a dividend. If they fall on hard times, that payout might get reduced or eliminated, but that's generally a last resort.

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For portfolio performance, it's hard to beat dividends

Dividends are often thought of as investments for retirees -- stable but slow-moving. However, the historical returns of dividend stocks are far from dull. Get this: According to Ned Davis Research, from 1972 through early 2016,dividend stocks averaged an annual gain of 8.8%versus just 2.2% for non-dividend payers. Indeed, from 1930 through 2014, dividends have accountedfor about 40% of the 10.3% average annual return of the S&P 500. See? Not so boring after all, are they?

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Dividend yields are more exciting than they look

A 3% or 4% dividend yield may not sound that impressive, but if that's the average overall yield you're getting on a $300,000 retirement portfolio, then you're looking at $9,000 to $12,000 in annual income.

Better still, when dividends are being paid by healthy, growing companies, they tend to grow over time, boosting your effective yield -- i.e., the yield you're currently receiving based on your original investment amount. For example, if a stock is currently trading at $100 per share and paying out $4 per year in dividends, then it yields 4% for those who buy now. But if you bought your shares years ago, when the stock was trading for only $50 per share, then that $4 dividend payment now translates to an effective yield of 8%. On top of all that, the underlying stock may have gained value over time.

Dividends can be tax-friendly, too. In the eyes of the IRS, dividend income falls into one of two categories:qualified or non-qualified. Much of investors' dividend income is qualified, which means it's subject to a lower tax rate. Qualified dividends are taxed at 0% if you're in the lowest two income tax brackets, 15% if your tax bracket is 25% to 35%, and 20% if you're in the top bracket. Non-qualified dividend income is taxed at your marginal income tax rate.

What stocks pay dividends?

Hundreds of stocks pay dividends, and many of them are household names. Here are just a few examples and their recent dividend yields:

Stock

Recent dividend yield

AT&T

5.1%

Ford Motor Company

4.8%

Verizon Communications

4.6%

Altria Group

3.8%

Chevron

3.8%

Pfizer

3.8%

IBM

3.5%

Coca-Cola

3.4%

ExxonMobil

3.4%

Procter & Gamble

3.2%

General Electric

3%

Intel

3%

Image source: Getty Images.

Dividend-hunting tips

Finally, as you search for great dividend-payers for your portfolio, here are some things to keep in mind:

  • Seek healthy, growing, promising companies -- because all dividends will be tied to the success of the companies that pay them.
  • Focus on the dividend yield, not the dividend amount --and, all things being equal, favor larger yields over smaller ones.
  • That said, be wary of huge yields. Sometimes an extraordinary dividend yield signals that a company is going through a rough time and losing share value -- not a company that loves to reward shareholders with hefty payouts. After all, the dividend yield is calculated by dividing the annual dividend amount by the current stock price; if the stock price drops, then the yield will rise. So take a close look at any yields that seem too good to be true.
  • Take note of how rapidly each dividend is being increased over time, because a company with a smaller yield could be the smarter buy if it's increasing its payout at a faster clip. In a few years, you might be reaping more income from a stock that yields 2% now than you would from a stock that yields 4% but has a stagnant dividend.
  • Examine the payout ratio, which reflects the portion of a company's earnings that's being paid out as dividends. In general, if the payout ratio is below 70% or so, then there's room for continued dividend growth. If it's 100% or more, then the dividend is unsustainable and may end up being reduced or eliminated. Bear in mind that a reasonable payout ratio can vary by industry. Real estate investment trusts, for example,have to pay out at least 90% of their income as a dividend.

Adding dividend payers to your portfolio can help it grow in the years before you retire and can provide valuable dividend income in retirement.

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Longtime Fool specialistSelena Maranjian, whom you can follow on Twitter, owns shares ofFord, General Electric, IBM, Procter and Gamble, and Verizon Communications. The Motley Fool owns shares of and recommends Ford. The Motley Fool owns shares of ExxonMobil and General Electric. The Motley Fool recommends Chevron, Coca-Cola, Intel, and Verizon Communications. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.