Diving into dividends are the benefits of stocks

Brad Olson | Apr 5, 2012, 10:56 a.m.

Dividends have traditionally been considered a source of income, but they can also be a powerful way to help build savings. A recent study found that dividends contributed 41 percent of S&P 500 total returns from 1926 through 2011. (1)

The keys to dividend performance are reinvestment and time. The power of compound interest is well known, but compounding dividends can be even more powerful because dividend payments may increase, potentially adding to the value of an investment.

Sharing Corporate Profits

Some companies pay a portion of their profits to shareholders in the form of dividends. The amount of the dividend is set by the board of directors and can be lowered, raised or stopped at any time. Generally, dividends are paid quarterly in the form of cash or stock.

Dividend-paying companies are typically mature, successful companies that may offer dividends as an incentive to buy their stock. These companies might not grow as quickly as newer companies that prefer to reinvest their profits for growth, but the stock of dividend-paying companies may be less volatile, and dividend payments may increase investors’ total return potential.

Many investors head for dividend paying stock as a way to play defense. This can be found in a stock that has healthy earnings and a relatively high dividend payout ratio and dividend yield, especially when compared to the yield that is available on the risk-free United States Treasury Bond. The reason is actually pretty simple: Investors are always comparing everything to this so-called risk free rate. And the reason for this is that when you buy a debt obligation of the United States, you can be certain that you are going to get paid. As the wealthiest nation in the world, all the government has to do is raise taxes or sell off assets to pay its debt.

When the dividend yield of a stock is the same as the Treasury bond, many investors would prefer to own the former. Not only do you get more cash from the dividend yield because of favorable tax treatment (dividends are subject to a maximum 15 percent federal tax rate while Treasury bonds, although exempt from state and local taxes, can run as high as the 35 percent tax bracket) but, perhaps more importantly, you get the capital gains generated from an increasing stock price.

Dividends are usually quoted by the dollar amount paid on each share. They can also be expressed as a yield—current yield is the annual dividend income per share divided by the current market price. When share prices fall, dividend yields rise (assuming dividend payments remain the same). This can make reinvesting dividends attractive because the dividend payments buy more shares, which have the potential to grow as market performance improves.

Paying Taxes on Dividends

Since enactment of a 2003 tax law, qualified corporate dividends have been taxed at a maximum 15 percent rate, like long-term capital gains. However, this special tax treatment expires after 2012, unless Congress takes further action. So in 2013, dividends will be taxed as ordinary income, with rates that could reach 39.6 percent. Keep in mind that dividends in qualified retirement plans such as 401(k)s and traditional IRAs accumulate on a tax-deferred basis; distributions from these plans are taxed as ordinary income.

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