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Advice

Money Matters

by Phil Star - July 29-August 4, 2010

Stock Dividends:
An Income Alternative

Since 2003, when the top federal income tax rate on qualified dividends was reduced, dividends have acquired renewed respect. When (or if) that tax rate increases (under current law, dividends will once again be taxed as ordinary income in 2011), the long-term demand for high-quality, reliable dividends will likely increase as baby boomers approach retirement and focus on income-producing investments.

Why consider dividends?

Because they can add to a stock’s total return, dividends can be especially important if the market produces relatively low or mediocre returns. According to Standard and Poor’s, dividend income has represented roughly one-third of the total return on the S&P 500 since 1926, though that percentage has declined over the last decade. Dividends also may mitigate the impact of a volatile market by at least partly offsetting price fluctuations to even out a portfolio’s overall return.

Many experts also look at dividends as a relatively reliable indicator of a company’s financial health. Investors have become more conscious in recent years of the value of dependable data as a basis for investment decisions, and dividend payments aren’t easily restated. Because dividends are one sign of a company’s financial health, boards of directors generally are reluctant to send investors a negative message by cutting dividends.

Also, many dividend-paying stocks represent large established companies that may have significant resources to weather economic hard times, which could be helpful if you’re relying on those dividends to help pay living expenses.

Finally, dividends become even more valuable if they’re reinvested rather than used to supply income. A dividend that’s used to purchase more of the company’s stock means you’ll receive a proportionally greater share of the company’s earnings the next time dividends are paid, which in turn means a larger dividend payment to be reinvested (assuming the company continues to do well and the dividend rate remains the same).

Look before you leap

Investing in dividend-paying stocks isn’t as simple as just picking the highest yield. If you’re investing for income, consider whether the company’s cash flow can sustain its dividend. Dividends on common stock are paid at the discretion of the company’s board of directors, and there’s no guarantee they won’t be cut.

Also, some companies choose to use corporate profits to buy back company shares. That may increase the value of existing shares, but it sometimes takes the place of instituting or raising dividends.

If you’re interested in a dividend-focused investing style, look for terms such as “equity income,” “dividend income” or “growth and income.” Also, some exchange-traded funds (ETFs) track an index that’s comprised of dividend-paying stocks or that’s based on dividend yield. Be sure to check the prospectus for information about expenses, fees, and potential risks, and consider them carefully before you invest.

All dividends are not alike

Some dividends, such as those paid by real estate investment trusts (REITs) and master limited partnerships, don’t qualify for the same maximum federal income tax rate as qualified dividends, and a portion may be taxed as ordinary income. Also, the 15-percent maximum rate is scheduled to expire at the end of 2010, and there is no guarantee dividends will continue to receive favorable tax treatment.

The 15-percent rate applies to qualified dividends (those paid by a U.S. or qualified foreign corporation). Also, you must have held the stock for more than 60 days during a 121-day period (60 days before and 61 days after the stock’s ex-dividend date). Form 1099-DIV, which reports your annual dividend and interest income for tax accounting purposes, will indicate whether a dividend is qualified or not.

Be aware that some so-called dividends actually are considered interest for tax purposes. These include dividends from deposits or share accounts at cooperative banks, credit unions, federal savings and loan associations and mutual savings banks.