Today I am going to share with you a guide on what dividend stocks are, how to find good ones and many more. Let’s get straight into it :
In case there is a term you don’t know check the Metrics
What is a Dividend Stock?
So pretty obvious a dividend stock is a stock that pays you dividends. They can be distributed either once a year, twice a year, once a quarter or every month depending on the company policy. Companies pay dividends to shareholders as a way to reward them for keeping their investment in the company.
Historically companies that pay out dividends have outperformed the ones that don’t. But just because a company pays dividend doesn’t always mean that it is a good investment. We will get into that later.
Dividend vs Non-Dividend Stocks Performance
How Do You Get Your Dividends?
In order to get your dividends you need to have shares in a dividend paying company. They are paid for every share you have in that company. Let’s say you have 5 shares of an ice-cream company. They pay a dividend of £1 every quarter. That means that you are going to get £5 every quarter as long as you keep your shares. That means that the more shares you have in that company the more dividends you are going to get every quarter. The beauty of all this is that you don’t need to do anything except for holding the shares. That is why dividends are such a great tool for generating passive income.
Are Dividend Stocks a Good Decision For You?
Well in my opinion they are a good decision for every investor and everyone who wants to have an early retirement. They are a fantastic option for putting your money to work for either young or more experienced investors. No one should underestimate the compounding powers of dividends, especially if you reinvest them back into your portfolio.
What is a Dividend Reinvestment?
That is simply when you buy more shares with your dividend income instead of taking the money out of your account. That way you can let compounding interest do its thing and you are going to see amazing results over time. You can see the difference in returns between reinvesting your dividends or not :
S&P500 Dividend Reinvestment Difference.
How to Find Good Dividend Stocks?
Now first of all you should ask yourself how much time are you ready to dedicate to manage your portfolio. There are some people that don’t have much time or don’t like reading financial statements and different stock screeners and that is completely normal. If you are one of them the best option would be to stick to index ETFs. If you would like to read more about ETFs you can see Here.
For those of you that like building their own portfolio and want to create their own one I suggest to first pick their Strategy and after that to check How To Research Dividend Stocks. There are of course some pros and cons of picking stocks yourself.
Pros
- You can get higher yield
- Can pick the companies that you like
Cons
- Need to diversify yourself. Index ETFs provide instant diversification
- More risk
What is Dividend Growth?
As a company grows their income usually their dividend grows aswell. Now let’s say you own shares in a company that pays out £1 dividends a year with 10% average dividend growth rate. That means in the second year the dividend is going to be £1,10. The next year it will be £1,21 after that £1,33 and so on. These numbers trully start amplifying when you reinvest those dividends and add monthly contributions aswell.
To give you a bit of perspective here is a graph of the dividend aristocrats and the S&P500 total returns. The dividend aristocrats are all the companies, which have increased their dividends every year for at least 25 years.
What is the Yield Trap?
As you start looking through dividend companies you are going to stumble on companies that have dividend yields in 20% or more. In first sight that sounds wonderful right? Well if something is too good to be true it most probably is and I will explain why.
The dividend yield is calculated by dividing the dividend paid to the share price. Let’s say that a company is paying £5 in dividends and their share price is £100. That makes their yield 5/100 or 5%. Now there are a couple of scenarios that the yield of a company is higher than average. Either their share price is too low or they are paying too much of their income as a dividend. For a company’s yield to be above 10% that almost always means that they are paying more than what they earn in dividends and that is never a good long-term strategy.
Most of the time that ends with dividend cuts and crippling debt, which is going to destroy shareholder value.
I personally never invest in companies with yields more than 8%. A yield higher than that is a red flag in 9/10 cases. That is why it is crucial to make a good research before investing your money.
Dividend Stocks and Financial Freedom
They both go hand to hand in most cases because of the fact how passive the dividend income is. Once you set up your portfolio you can forget about it and the dividend checks are going to come in no matter what you are doing or where you are. Over time dividends can give you a good enough income that you don’t need to work anymore and have the freedom to do whatever it is that you like doing.
Dividends and Taxes
Taxes on dividends can vary depending where you live.
In the UK for example the first £2,000 are not taxable and after that you pay either 7.5% ; 32.5% or 38.1% depending on the amount of income that you get.
In the US you will have to pay between 10% to 37% depending on how much income you have.
If you hold international stocks in your portfolio the dividend tax can vary depending on the policies between the countries. For example a UK investor holding US stocks is going to pay 15% tax on their US dividend, because both countries have a tax treaty.
Can You Reduce Your Tax on Dividends?
This is a question that probably a lot of people ask themselves and the asnwer is yes you can. There are different financial services that allow you to shelter some or even all of your dividend income from taxes.
Such is the S&S ISA(Stocks and Shares Individual Savings Acount). It lets you invest up to £20,000 every year that are tax-free. All the dividends that you receive there and all the capital gains are tax-free and you don’t have to pay any tax on them.
Other good way to reduce taxes is a SIPP(Self-Invested-Personal Pension). You can contribute to your SIPP with your pre-taxable income and you can start withdrawing once you turn 55. 25% of those withdrawals is tax-free and the rest is taxed as income.
For the US similar options are an IRA, Roth- IRA, 401K and others.
In my opinion it doesn’t make any sense not to take advantage and max out those offerings. Doing that is going to reduce the amount of tax that you pay tremendously.
Closing Thoughts
Dividends are a fantastic opportunity to grow your wealth and retire early. The combination of regular contributions, dividend growth and reinvestment can show the true power of compounding. They are a good option for both young and experienced investors.
You still need to be careful with picking dividend stocks because there can certainly be some traps along the way.
That is all from me, hope you learned something new about dividend stocks, if you have any questions don’t hesitate to contact me.
Very informative and Easy to read. Great Job!