What if you could collect a steady and predictable income without having to lift a finger? Better yet, what if that income were to increase every year at a rate greater than inflation (meaning you earn more over time)? Sounds pretty good, right? Well this idea is not hard to obtain. Dividend paying stocks provide an excellent source of passive income and there are several reasons to own dividend paying stocks. In fact, I plan on having dividends provide somewhere between 25% and 33% of my monthly retirement income.
First, you may be wondering what the heck is a dividend? Individuals may buy stock in publicly traded companies. Many publicly traded companies share their profits with stock owners (shareholders) in the form of dividends. Dividends are cash payments by a company to the shareholders. Cash dividends accounted for 71% of the market’s overall returns over the last 40 years. These payments typically occur quarterly but can also be monthly, semi-annually or annually.
Dividends allow investors to capture returns without selling the underlying asset. A dividend provides you with cash while allowing you to still own the business. The business’ value can appreciate over time while continuing to provide more dividends. As an investor, you should never have to sell your asset in order to earn a return. Additionally, I would never own a stock that does not pay a dividend. Why would you own an asset that does not provide a return?
Dividends have preferential tax treatment. What does this mean? Dividend income is subject to capital gains tax and not income tax. Most people will pay a 15% tax rate on dividend income… Unless you are a complete baller and fall into the highest income tax bracket, then you will pay a 20% tax rate on dividend income.
Most companies generally increase their dividend payments annually. Some years the dividend increase may be north of 10% while other years shareholders enjoy a modest 4-5% increase. Typically, dividend increases out-pace inflation; this serves as a great hedge against inflation and way to preserve purchasing power. Companies that have a strong track record of continually growing their dividends are known as Dividend Aristocrats.
Now that we have established what a dividend is, the next logical question is what to do with a dividend? There are two schools of thought on utilizing dividends.
The first practice is known as a dividend reinvestment plan or a DRIP. A DRIP allows an investor to take the cash from the dividend payment and reinvest it back into the company that paid the dividend. Numerous companies offer DRIPs and there are several advantages to dripping. By participating in DRIPs, investors can purchase fractional shares, avoid costly transaction fees and even receive a discount on their purchase (discount only offered by some companies and typically ranges between 1% and 10%). Jim Cramer is a big believer in DRIPs.
Alternatively, investors can elect to receive their dividend in the form of a cash payment. There are limitless options once the investor has received the cash. The investor could elect to buy another company with their funds from dividend payment. This would provide an additional dividend income stream and increase diversification. This would also add to the power of compounding interest.
Additionally, the investor could use the cash to pay for bills or go on a vacation. Or, the investor could actually buy more stock in the company that paid them the dividend at a price of their choice. Warren Buffet never participates in DRIPs and utilizes the dividend income to buy additional stock at his price.
Over the course of my journey, I will be tracking and providing quarterly updates on my dividend income. The goal is to grow my dividend income through two methods. The first will be organic growth of my existing portfolio by companies naturally increasing their dividends over time. Secondly, I will opportunistically invest new money to increase my dividend income.
There are several compelling reasons to own dividend paying stocks. Dividends are a good source of passive income. Over time, dividends typically outpace inflation which serves as a hedge against inflation while preserving purchasing power. Dividend income has preferential tax treatment compared to wage income. Lastly, dividends have made up a majority of the market’s returns over the last 40 years. Are you collecting dividends? If not, you might want to ask yourself why.