Investors seeking income often turn to dividends because of their advantages over bonds and bank deposit accounts. Dividends not only provide consistent cash flow, but they can also allow investors to participate in the appreciation of the asset as well. Plus, dividends provide favorable tax treatment if you’ve held the securities long enough. In this article, we’ll explain what dividends are, why you want them and how to build a dividend portfolio in 2022 – as well as the danger of inflation to a dividend portfolio. For help building your own dividend-focused portfolio, consider working with a financial advisor.
What Are Dividends?
Dividends are the periodic or one-off distributions of a portion of the company’s retained earnings to shareholders. These distributions are typically made as cash or additional shares in the investment. For every share of stock, ETF or mutual fund that you own on the ex-dividend date, you’ll receive a dividend.
Companies pay dividends on a fairly consistent basis. Depending on which investments you choose, the dividends may be monthly, quarterly, semi-annually or annually.
Investors choose to invest in assets that provide dividend income for multiple reasons. These are the most common:
Potential for increased distributions over time
Appreciation of underlying assets
Qualified vs. Non-qualified Dividends
If you’re investing in a taxable brokerage account, qualified dividends offer tax benefits that can reduce taxes owed on dividend distributions. In order for your dividends to be considered qualified, you’ll need to own them for a specified period of time before the ex-dividend date. For stocks, the shares must be owned for at least 60 out of 121 days for the period beginning 60 days before the ex-dividend date. If the ex-dividend date is December 10th, the 121 day holding period begins October 11th.
With qualified dividends, you are taxed at the capital gains rates based on your tax bracket. This means that some investors can pay less in taxes on dividends than ordinary income and interest. Non-qualified dividends are those that don’t meet the holding period requirements. In that case, dividends are taxed at ordinary income tax rates.
How Is Dividend Yield Calculated?
When analyzing potential dividend-paying assets, it helps to calculate the dividend yield of the investment. The dividend yield allows you to compare dividend-paying assets against each other, as well as to other investment alternatives (e.g.: bonds, CDs, high-yield savings accounts, REITs).
To calculate an investment’s dividend yield, take the annual dividends paid divided by the current stock price. For example, an investment that pays $5 in dividends with a stock price of $100 has a dividend yield of 5%. Because prices change every day, an investment’s dividend yield may change throughout the year.
Is a High Dividend Yield the Best Choice?
Because of a dividend’s appeal, some investors may seek out the investments with the highest dividend yields possible. While this may sound like a good strategy on the surface, it can lead to problems in some situations.
Dividend yields rise when companies increase dividends, but they also rise when a stock’s price falls. If the price falls too much, its dividend yield can spike. When this happens, it is possible that dividends may be cut or suspended to bring them back to historical percentage levels. Additionally, the investment may be at risk of bankruptcy or closing down for good.
How to Build a Dividend Portfolio for 2022 and Beyond
To create your dividend portfolio for 2022 and beyond, it helps to incorporate these features into your investment strategy.
Taxable vs. Retirement Account
When you invest in dividend investments within a retirement account, you do not have to worry about the tax status of the dividends. However, when investing through a taxable brokerage account, try to time your purchases so that your dividends are qualified. Qualified dividends are taxed at the same rates as long-term capital gains.
Individual Stocks vs. Mutual funds/ETFs
You can invest your dividend portfolio in stocks, mutual funds or ETFs. Each has its own unique pros and cons. With individual stocks, you can hand-select which companies to own and which to sell. Additionally, you can choose the timing of your purchases to ensure that you receive qualified dividends.
Mutual funds and ETFs offer instant diversification of your portfolio and professional management that chooses individual companies on your behalf. These funds buy and sell stocks regularly, so you may receive a mix of qualified and non-qualified dividends, as well as short- and long-term capital gains through no fault of your own.
Consistent Track Record
When analyzing potential investments for your dividend portfolio, look for a consistent track record of dividend payments. A company that has paid its dividends every period without fail is often a better choice than one that has started and stopped payouts numerous times. Additionally, companies that regularly increase dividends can help you keep up with inflation and boost your income.
Sector Investing in Your Dividend Portfolio
Some sectors pay dividends more than others. Utilities, telecommunications and consumer staples historically have offered the highest dividend yields. Conversely, small company stocks and technology companies tend to reinvest their earnings to grow revenues, so many of these companies tend not to offer dividends. Or, if they do, the yields are much lower on average.
While you are building your dividend portfolio, don’t forget to diversify your investments. Concentrating your money in one stock or sector can increase risk dramatically within your portfolio. Mutual funds and ETFs automatically provide diversification at the company level, but they can still be concentrated in a particular geography, sector or asset class.
Impact of Inflation on Your Dividend Portfolio
While building your dividend portfolio, one major risk to be aware of is the impact of inflation. Inflation eats away at the value of your income and erodes your purchasing power over time. This is why it is important to select companies that have a history of increasing dividend distributions that outpace inflation.
For example, if you have $100,000 in your dividend portfolio that yields a 4% dividend distribution, you’ll receive $4,000 per year. With a 3% inflation rate, goods and services will cost 50% more within 15 years. If your dividend distributions are not keeping up with inflation, your ability to pay your bills and enjoy your lifestyle could be greatly affected.
The Bottom Line
Building a dividend portfolio is a smart way to create consistent income. With this strategy, you’re earning money on a regular basis, while also participating in the growth of the underlying stocks and potentially benefiting from tax advantages as well.
Tips for Creating a Dividend Portfolio
Retirees have numerous options when it comes to creating retirement income. A mix of Social Security, pensions, a dividend portfolio and other investments can often meet their needs. Growing your portfolio can generate larger dividends in the future. See how big your portfolio can get using our investment calculator and changing the amounts, timeframe and annual rates of return.
It can be challenging to pick the right dividend portfolio investments, but a financial advisor can help. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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