How to Invest in Dividend Stocks

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How to Invest in Dividend Stocks

Investing for the long haul is the smartest way to build long-term wealth, yet investors use different strategies to get where they want to be. Investing in individual stocks can be a good strategy if you can put in the time and research required to make good picks — and have luck on your side. 

Beyond that, it’s wise to build a diversified portfolio that includes a broad range of investments to spread your risk and increase your chances at excellent long-term returns.

One commonly shared tip in investing circles involves investing into dividend stocks. With dividend stocks, you can earn money in more than one way — your stocks can grow in value over time, but you can also earn dividends that help boost your returns even more over time.  

What are Dividend Stocks?

Dividend stocks are a type of stock that’s offered by companies. As its name suggests, these stocks pay out dividends to their investors. Dividends can be paid out by exchange-traded funds (ETFs) or mutual funds.

Either way, your investment has the chance to increase in value over time, and you’ll be paid a dividend based on company profits and performance. From there, you can decide how to handle the dividends you’ve earned. 

For example, you can do what most smart investors do and reinvest them (usually automatically) into the company. You can also use them to buy stock in a different company, or you can cash them out and spend them how you wish. 

One interesting detail about dividend stocks is that dividends are guaranteed even though your investment returns are not. Even in an awful year where the value of your stock goes down, you can usually expect dividends to be paid out as normal. 

You might wonder why anyone wouldn’t want to invest in dividend stocks. After all, having the chance to watch your investment grow in value is good, but isn’t earning dividends on top of that even better?

The answer to this question may not be as cut and dry as it seems. Sure, dividend stocks are popular for a reason. However, there are some potential downsides you should know about:

Pros

  • Dividend stocks are usually offered by profitable companies, so they can be seen as less risky
  • You get the chance to earn dividends on top of investment returns
  • A broad range of stocks, ETFs and mutual funds offer dividends, so you have plenty of options to choose from
  • People in the lowest tax brackets don’t pay any income taxes on qualified dividends

Cons

  • Companies have the option to eliminate or reduce their dividend payouts at any time
  • Dividends are considered taxable income, although your tax rates will depend on the status of your dividends (qualified or non-qualified) and your income
  • Expense ratios for dividend stocks, mutual funds and ETFs can be higher than investment options without dividends (but not always)

How to Invest in Dividend Stocks

Dividend stocks give investors a chance to earn dividends in real-time, even if they’re investing for the long haul. And if you’re someone who wants to build as many passive income streams as possible, building a solid portfolio of dividend stocks can help you reach your goals faster.

Here are the basic steps to investing in dividend stocks if you want to get started.

Step 1: Open and Fund a Brokerage Account 

The first step to investing in dividend stocks is opening a brokerage account if you don’t have one already. Fortunately, there are an array of popular investing platforms for beginners or seasoned investors, and many let you invest in stocks without any trading fees. 

For example, the investing app, Robinhood, lets you invest into dividend-paying stocks without any trading fees, and your dividends are paid out automatically. Another solid option is M1 Finance since it also lets you invest into dividend-paying investments without any commissions or fees. 

Of course, any major brokerage, like Fidelity, also lets you invest in dividend stocks of your choosing. Make sure to compare all the top brokerage accounts to find one with the investment options and online tools you want, as well as costs you’re comfortable with.

Step 2: Compare Dividend Stocks and Important Metrics

When it comes to stocks that pay dividends, the majority come from big businesses that have a long history of profitability — think companies like PepsiCo, Cisco Systems, and Starbucks. 

However, not all companies that pay dividends are quality firms that provide solid returns and low volatility for the long haul. Do your homework and compare the best options out there.

You can start the process by making a list of companies you might want to invest in, then see which stocks offer dividends to investors. From there, compare companies based on their “dividend yield”, which is a ratio that shows how much companies pay in dividends each year when compared to their stock price. 

Although the dividend yield is based on the current stock price and current dividend payouts, which are both subject to change, this metric can give you a basis for comparison. As of writing, some of the highest paying dividend stocks include Exxon Mobil (XOM), Lumen Technologies (LUMN), and Mobile TeleSystems (MBT). 

Step 3: Research Companies’ Financial history 

Although a company’s stock dividend yield gives you a glimpse into what you can expect if you invest, you’ll also want to compare firms and research their financial history. Look for companies that have had a solid history of performance and growth since they’ve been around, and firms that have relatively low amounts of debt — or at least, not so much debt that’s bound to stunt their growth. 

Review each company’s profit margins, which is a key metric that determines how much in dividends might be paid out to investors each year. 

Step 4: Look at Expense Ratios and Other Costs

Stocks don’t have expense ratios, but ETFs and mutual funds do. The brokerage firm you decide to invest with might also charge an account management fee or other ongoing fees. 

The fees you’ll pay to invest will dramatically eat away at your returns — ignoring the cost of investing and focusing on dividend yields alone is never smart. Some funds might offer exceptional dividends but charge high expense ratios that drop your returns quickly. 

Whether you want to invest small amounts of money or have a large sum of cash to invest into mutual funds or ETFs that pay dividends, understand all fees you’re expected to pay.

Step 5: Start Investing and Automate It

Once you know which dividend stocks you want to invest in, use your funded brokerage account to get started. Keep in mind that many online brokerage firms let you invest with no minimum balance or as little as $100 (like M1 Finance). You might also be able to invest with small amounts, thanks to fractional shares

Our suggestion: Start investing in dividend stocks as soon as you’re ready, then set up an automatic investment amount for each month or each payday. 

If you want to build long-term wealth without having to worry about staying on top of your investing plan, setting up automatic investments from your checking or savings account is the easiest and best way to do it. 

How are Dividends Taxed?

One of the major downsides of dividends is the fact they’re considered taxable income. However, the amount of tax you pay varies dramatically depending on your income and the length of time you hold your investments.

When it comes to taxation on dividends, some dividends are considered “qualified” while others are “nonqualified.” 

Generally, dividends paid on common stock from U.S. companies are considered qualified if you hold them for 60 days or longer. The fund must also be more than 60 days old. According to Vanguard, “stocks offered by foreign companies that are traded through American Depositary Receipts (ADRs) or on U.S. markets may also be qualified.”

The difference between qualified and nonqualified dividends might not seem important, but it is when you consider the tax implications. Where qualified dividends come with tax rates of 0%, 15% or 20% based on your income, nonqualified dividends are taxed like your regular income. 

Whether you have qualified or nonqualified dividends, the income you receive from dividends will be reported to you using IRS Form 1099-DIV.

The Bottom Line

Some investors swear by dividend stocks for their potential for higher returns. But like other investments, the key to winning with dividend stocks is making sure you invest with the right companies — and with a goal in mind.

This article provides some cursory information that can help you get started, but you’ll need to research on your own from here. Compare companies and stocks that pay out dividends, but don’t forget to review their financials and read the fine print. 

Some dividend stocks look good on paper but aren’t that great in reality. Likewise, there are hidden gems out there if you take the time to look.

Keep reading: How to Buy Stocks Online For Free

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