Are higher dividend yields always better than low ones? Are dividend stocks always safe? And are all dividends taxed the same?
Dividend investing can be one of the most certain paths toward long-term wealth, but it's important to separate fact from fiction. There are several myths or misconceptions many investors have regarding dividend stocks, and we'd like to clear these up for our readers. So we asked three of our analysts to pick one of these popular myths about dividend stocks and explain why it may not be entirely accurate.
Brian Stoffel: One of the easiest dividend myths for beginning investors to fall for is the idea that higher yields are intrinsically better.
On one level, it makes sense: Who wouldn't want to recoup 5% or more of their investment? But dig a little, and that line of thinking starts to fall apart.
For starters, the yield itself is calculated by dividing the payout by a stock's overall price. That means that for there to be a high yield, the stock price (the denominator) needs to be significantly lower -- relative to the dividend -- than the S&P 500's average yield of 1.9%.
Oftentimes, there's a solid reason for that lower stock price. Take low-end cigarette maker Vector Group (NYSE:VGR) as an example. Currently, the company's stock offers a 7.1% dividend yield. But look back over the past 12 months, and the company has brought in $71.5 million in free cash flow while paying out $164.4 million in dividends.
That math just doesn't add up, and it helps explain why Vector has had to find way to finance its yield beyond cash that it's able to generate from its operations. In Vector's case, a move into New York real estate -- of all things -- could provide some relief. But for the time being, the yield is high probably because many investors don't think it will be around for much longer.
Dan Caplinger: One false idea that many people have about dividend stocks is that they're safer than non-dividend-paying stocks. It's true that many of the dividend stocks that are favorites among conservative investors are well-established, mature companies in slow-growth industries and tend to be less volatile than higher-growth stocks. Yet even some of the best-known companies in the market have failed their dividend investors in the past, as changes in economic conditions or other company-specific situations have forced them to take action to conserve cash even at the expense of income-hungry shareholders.
For instance, during the financial crisis, General Electric (NYSE:GE) had to cut its dividend, breaking a streak of 32 consecutive years of dividend increases when it slashed its payout by more than two-thirds in 2009. The industrial giant had overextended itself with its finance arm, leaving itself vulnerable to toxic assets throughout the financial industry.
Similarly, Pfizer (NYSE:PFE) halved its dividend in 2009, ending its 41-year run of annual dividend boosts in the wake of its acquisition of Wyeth. Although Pfizer has regained investors' confidence, General Electric remains well below its pre-crisis levels five years later. Those are just two examples of how even blue-chip dividend-paying companies can fall from grace when things go wrong.
Matt Frankel: One myth or misconception about dividend stocks is that they're all taxed the same. In reality, dividends fall into two categories for tax purposes: qualified and ordinary.
Qualified dividends are taxed at much lower rates, which are actually the same rates as long-term capital gains. On the other hand, ordinary dividends are taxed as ordinary income, or at your marginal tax rate. The difference can be substantial. If you're in the 28% tax bracket and receive $2,000 in dividends this year, you would pay an additional $260 in taxes if your dividends don't meet the "qualified" criteria.
What is a qualified dividend? First off, for a dividend to be qualified, it must be paid by a U.S. corporation, or by a foreign corporation that is readily traded on a major U.S. exchange (American depositary receipts, or ADRs, qualify). Also, you must have held the stock for more than 60 days of the 121-day period around the ex-dividend date (60 days before through 60 days after). For preferred stock, you must hold for 90 days of the 181-day period around the ex-dividend date.
So if you trade on foreign exchanges often, or tend to hold dividend stocks for short time periods, you may be paying more in taxes than you realize.
Brian Stoffel has no position in any stocks mentioned. Dan Caplinger owns shares of General Electric Company. Matthew Frankel has no position in any stocks mentioned. The Motley Fool owns shares of General Electric Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.