High-yield stocks can certainly make great additions to long-term investment portfolios, but there are a few things you need to know before you get started. Specifically, higher dividends aren't always better than smaller ones, some companies have no choice but to pay high dividends, and not all dividends are taxed in the same manner by the IRS. Here's a rundown of these concepts and what all high-yield dividend stock investors needs to know about them.
Bigger isn't always better
All other things being equal, it's obviously better to get a 5% dividend yield from a stock than a 4% dividend yield. However, all other things are rarely equal, and bigger dividends are not necessarily better.
For starters, a dividend is only as good as the company that is paying it. Specifically, it's a good idea to take a look at a company's dividend history and growth rate, as well as the company's debt load and credit rating, and to use this information when evaluating dividend stocks.
As an example, let's say that you're looking at two stocks. One is a rock-solid company with a 50-year history of dividend increases and a 3% dividend yield. The other is a less stable company with a history of unpredictable dividend increases and decreases, but that currently yields 5%. In situations like this, the first one is usually the better investment.
In addition, beware of dividends that seem too good to be true. One metric all dividend investors should know is the payout ratio, which is a company's annual dividend rate divided by its earnings. So, a company that earned $1.00 per share in 2017 and paid out $0.40 in dividends would have a payout ratio of 40%. I generally look for companies with payout ratios of 60% or less, although there are exceptions that I'll get to in the next section. In any case, a payout ratio that is close to, or over 100% can be a major red flag that the dividend may not be sustainable.
Some stocks have to be high-yield
While bigger isn't always better, and excessive payout ratios can be signs of trouble, it's also important to know that some types of stocks are required to pay out most of their income as dividends. Real estate investment trusts (REITs) and master limited partnerships (MLPs) are two examples.
Specifically, REITs are required to pay out at least 90% of their taxable income to shareholders to maintain their REIT classification. If they do this, their profits are not taxed at the corporate level, and the companies are treated as pass-through entities.
Master limited partnerships, or MLPs, are similar in structure to REITS and generally own commodity-related assets, specifically oil- and gas-related assets.
Why is this important? Well, if you follow my "payout ratio" guideline in the previous section, these stocks may seem like they're paying out way too much to be sustainable. In fact, because of accounting concepts like depreciation, many have payout ratios well in excess of 100%. For example, one of my favorite REITs, Public Storage, pays $8.00 in dividends annually, but only earned $6.73 per share over the past 12 months -- a payout ratio of 119%. Just keep in mind that this is completely normal and not necessarily a sign of trouble. In fact, REITs have their own set of metrics investors should use to evaluate them.
Know the tax implications of your high-yield stocks
This one mainly applies to investors who own, or plan to own, dividend stocks in taxable (non-retirement) brokerage accounts.
In a nutshell, there are two main categories of dividends for tax purposes: qualified and non-qualified. Qualified dividends are taxed at favorable rates, while non-qualified dividends are taxed as ordinary income according to the current tax brackets. For a dividend to be "qualified," it must be paid by a U.S. corporation, or a foreign corporation listed on a major U.S. exchange, and a certain minimum holding period requirement must be met.
However, it's important to know that distributions from pass-through entities like REITs and other high-dividend types of stocks are typically treated as non-qualified dividends.
Here's the point: Before you choose a high-dividend REIT or MLP in a taxable account because of its high yield, make sure you're aware that you may end up owing more taxes than you otherwise would with a "qualified" dividend stock.