Dividend Stock Basics

by Harry Domash 

Here’s a novel idea: Buy stocks that pay you to own them! They are called dividend-paying stocks, and you make money, even if they don’t go up much.

Better still, stocks with solid dividend prospects don’t go down as much as other stocks, because when they try, the resulting dividend yield boost attracts more buyers.

Dividends Defined
Dividends as used here, means cash dividends that companies pay on a quarterly basis. We’re not considering stock dividends sometimes used to implement stock splits or company spin offs, or one-time cash payments.

Normally, your broker adds your received dividend to your cash account. However, many also offer automatic reinvestment plans. With these plans, your dividends are used to purchase additional shares, even if the dividend equates to only a fraction of a share. 

Dividend Stock Types
Utilities frequently come to mind when talk turns to dividends. But banks and a variety of manufacturing and service companies also pay significant dividends. These stocks pay dividends typically equating to 4% to 5% yields, but some run higher. Generally, speaking, yields from manufacturing and service companies above 6% signal concerns about the firm's ability to maintain its payout at current levels.

The maximum income tax on dividends paid by banks, and manufacturing and service companies, is currently 15%. These dividends are termed "qualified dividends" because they qualify for the 14% maximum income tax rate.

Many investors look to tax-advantaged entities such as real estate investment trusts (REITs), Master Limited Partnerships (MLPs) and Business Development Companies (BDCs) for higher yields. REIT’s MLPs, and BDCs do not pay corporate income taxes as long as they pay out most of their earnings to shareholders. However, their shares trade on the major exchanges, the same as any other stock. Their dividend yields typically range between 4% and 10%, and in some instances, even higher. Dividends paid by REITs and BDCs are mostly taxed at ordinary rates, so if possible, hold them in tax-sheltered accounts. MLP dividends are mostly not taxed until you sell your shares.

REITs, MLPs & BDCs
REITs are required to invest only in real estate. There are two types of REITs, property REITs and mortgage REITs. Property REITs own real estate such as shopping centers, office buildings, residential apartment complexes, etc. Mortgage REITs do not own property, instead, they invest in mortgages. For more, see About REITs.

MLPs are managed by general partners. Other investors are termed unit holders (shareholders) and are limited partners. MLP tax advantages appeals to major energy companies and many have transferred their petroleum and natural gas pipeline assets to MLPs that they control as general partners. MLPs offer a potential tax advantage to you because a portion of their payouts, termed distributions, can be tax-deferred. However, they may not be suitable for tax-sheltered accounts, so consult your tax advisor before putting them into IRAs, 401k plans, etc. For more, see About MLPs.

BDCs are special purpose entities formed to provide financing and management assistance to small- and mid-sized companies. For more, see About BDCs. 

See the Dividend Stock Checklist for hints about how to pick the best dividend stock candidates.

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