In this era of ultra-low interest rates, investing in dividend-paying stocks is increasingly lucrative for investors looking for income. However, we also live in incredibly disruptive times. Many companies considered stalwart not so long ago are currently on shaky ground as the world shifts to a new digital era. Thus, for those nearing or in retirement, investing in stocks of any kind -- even dividend-paying ones -- presents new challenges.
But contrary to some beliefs, investing in fixed-income assets like bonds is not risk-free, it simply bears different risks than investing in stocks does. And managing a portfolio of income-generating businesses is far from out of the question.
However, a few tips can go a long way toward maximizing gains.
1. Know your tax rate
For starters, it's important to know that dividends could get taxed. For the 2020 tax year, single filers will pay 15% tax on qualified dividends if taxable income falls between $40,000 and $441,450 ($80,000 to $496,600 for joint filers). If taxable income is below that amount, dividends are free and clear -- but above those income limits, Uncle Sam gets a 20% cut.
This can be incredibly handy info when planning out an investment strategy and deciding what type of account to invest in, like a taxable account versus a Traditional IRA. If income falls below the taxable threshold, there's no need for worry, as dividends (as well as long-term capital gains) are yours to keep in full. Above those limits, though, where you stash your investments matters.
For example, if you file a joint tax return and you expect current-year and future taxable income to be above $80,000, that lands you in the 22% tax bracket, higher than the 15% tax rate on dividends. Thus if you plan on making dividend payments part of your income stream in the near future (versus reinvesting them), owning dividend-paying stocks in a taxable account rather than a Traditional IRA (where withdrawals get taxed as ordinary income, or 22% in this example) makes more sense. The problem becomes even more pronounced for higher-income earners, making that possible 15% to 20% tax rate on dividends that much more appealing. If you plan on buying dividend-paying stocks and immediately making the income part of your annual budget, consider investing in a taxable account versus a Traditional IRA (if that's a consideration in your circumstances).
Of course, if you have a Roth IRA that's been established for at least five years this is a non-issue, as withdrawals are all tax free after one has passed age 59 1/2. And a diversified portfolio with a variety of stock holdings is good sense, regardless of whether it's taxable or not. However, when deciding where to allocate funds for retirement use -- especially if retirement is right around the corner -- it pays to know the tax brackets and what the implications of owning shares of a company will be for you.
2. Focus on future yield over current yield
Some dividend investors gravitate toward the highest-paying yields. But while some high-yield stocks may be just fine, they might also be an indication of trouble. Remember, there's no such thing as a free lunch, and a higher potential return means higher risk -- in this case, the possibility a dividend payment being at risk of getting cut or eliminated if a company is cash-strapped. More on that in a minute.
However, a factor that could far outweigh a currently high-yielding payment is the power of future dividend-paying potential. Healthy companies that dole out extra cash to their shareholders are also often on the lookout to increase those payments over time. As the years go by, what started out as a modest sum can grow into a comparatively massive payment. One such example is Home Depot (NYSE:HD).
In 2011, Home Depot paid out $0.29 per share each quarter (or $1.16 a year). If you purchased 28 shares at the start of the year, or about $1,000 worth, dividends paid to you would have been $32.48. Fast forward to today, and Home Depot now pays $1.50 per share each quarter. Along the way, shareholders were treated to some exceptional share-price growth, and that initial yield has ballooned. If you still had the same 28 shares, the $32.48 a year payout on your initial investment is now yielding $180 a year. Not a bad return on $1,000, huh?
The point is this: Don't get too hung up on current yield. Look instead for companies that are growing their dividend payouts. A business that is generating even a little revenue growth, but turning that into an even higher rate of profitability growth, is an exceptional long-term income investment.
3. Learn to understand free cash flow
To help in the search for companies that are generating excess cash, it's important to know how to calculate free cash flow. Free cash flow is revenue less cash operating expenses and capital expenditures (like for equipment), and gets added to or subtracted from the balance sheet at the end of every quarter. Free cash flow, not net earnings, is what pays the bills -- including your quarterly payment. If it runs too lean or in negative territory for too long and starts to drain a company's reserves, a cut to your payout might be coming.
Here's how to calculate it yourself, again using Home Depot as an example. On the company's first-quarter 2020 report (find it here), scroll down to the "condensed consolidated statements of cash flows" section. The first part of the table lists "cash flows from operating activities." We want the last line item that lists net cash provided by operating activities, in this case $5.74 billion. But to get free cash flow, we need to subtract capital expenditures and add back any other non-recurring non-operating items that generated cash, listed under the next section "cash flows from investing activities." Subtracting $586 million in capital expenditures and adding back $8 million from the sale of property and equipment shows that Home Depot generated $5.16 billion in free cash flow during the first three months of 2020.
Now let's compare that to dividends paid. Under the last section of the chart, "cash flows from financing activities," there's a line item that lists cash dividends paid. This is all outstanding shares multiplied by the quarterly dividend payment (we already know that's $1.50 per share each quarter), making for a grand total of $1.61 billion paid out in cash to shareholders. Thus, free cash flow minus cash dividends still left Home Depot with $3.55 billion in excess cash at the end of Q1 2020. This is one solid dividend stock with lots of room to continue increasing its payout.
But why spend time understanding free cash flow? Because it's an important tool in assessing the relative safety of a stock's dividend payout, and -- paired with the balance sheet (specifically total cash and debt) -- the general viability of a business overall. Knowing full well what kind of financials back up a dividend payment before making a purchase can save an investor from a nasty surprise later on down the road.
These are but a few items to consider when investing in dividend-paying stocks, but they can add up to thousands in extra earnings every year. Here's a more extensive list of things to look for in assessing whether a business belongs in your income-generating portfolio.