Caution Tape

Source: Flickr user Eugene Zemlyanskiy.

Dividend investing can be one of the best paths to wealth, but there are some mistakes to avoid. For example, not all stocks that pay high dividends make good investments, and buying stocks solely for their dividends is generally a bad idea. With that in mind, here are three rookie mistakes to avoid when constructing your dividend portfolio.

Don't ignore taxes
One mistake that can literally cost you thousands of dollars on otherwise good dividend investments is failing to plan for taxes.

Taxes Sign

Source: 401kcalculator.org via flickr

If you hold your dividend stocks in a standard brokerage account, you'll have to pay taxes on the dividends you receive. If your dividends meet the definition of "qualified," you'll end up paying between 0% and 20% (most people pay 15%) depending on your income. And, if your dividends aren't qualified, you'll end up paying your ordinary income tax rate. Keep in mind that you'll have to pay dividend taxes even if you choose to automatically reinvest your dividends.

Fortunately, by holding your dividend stocks in tax-advantaged accounts like IRAs, you can avoid paying dividend taxes, which can really boost your gains over the long run.

As an example, consider one of my favorite dividend stocks in my own portfolio: Qualcomm, which currently pays about 3.5% per year. If Qualcomm's share price and dividend both increase at 8% per year (a reasonable goal), a $10,000 investment in Qualcomm could be worth more than $252,000 in 30 years and pay out $8,850 in annual income.

Of course, this assumes I hold my shares in a taxable account. If taxes take a 15% bite out of my dividends every year, leaving me with less money to reinvest, my investment's final value would be about $218,000 -- still a great return, but the choice to hold the shares in a taxable account would cost more than $34,000 in investment gains.

So, it's important to consider taxes when buying stocks. Personally, I maintain both taxable and non-taxable accounts. My taxable account is full of stocks like Google and Berkshire Hathaway, which have excellent long-term prospects but don't pay dividends, while I make sure to purchase my dividend-paying stocks in my IRA.

Don't assume higher yields are better
One common mistake is buying a dividend stock simply because it has a high yield. A stock's dividend yield is just one small part of the overall picture that needs to be considered. Specifically, you need to decide if a dividend yield is high because the stock is undervalued (good reason) or if the dividend is high because the underlying business is in trouble.

For example, if you read financial news at all, you know that oil prices have been beaten down lately, which has in turn put pressure on the prices of oil stocks. And when prices drop, yields rise. ExxonMobil stock has lost more than 23% of its value over the past year, but its dividend yield has grown by 40% to 3.84% in that time. I've written several times that ExxonMobil's business is just fine from a long-term perspective, so this is a good reason a dividend yield is high.

On the other hand, there are some red flags to look for that could tell you if a dividend is high for a bad reason. Just to name a few:

  • If a stock is paying out too much of its earnings as dividends. For example, if a stock earned $4.00 per share last year but paid out $5.00 in dividends, it could be a sign that the dividend is not sustainable. There are a few exceptions to this, such as REITs and other companies that have to pay out most of their earnings, but in general a high payout ratio is a red flag.
  • If a stock has a shaky dividend history, you should probably avoid it as a long-term investment. For example, Annaly Capital Management pays a sky-high 11.9% dividend, but the nature of its business makes the company's profits extremely inconsistent. As you can see, Annaly's dividend history is erratic, which makes it a speculative long-term investment at best.

NLY Dividend Chart

  • Companies in weak industries (like energy) that are not the sector leaders should generally be avoided. I already mentioned that ExxonMobil is still a good investment. However, many weaker companies in the sector such as Transocean and Chesapeake Energy have already cut their dividends and future prospects are shaky.
  • Profits have been declining or growth has been slowing down. The best dividend stocks consistently increase their dividends over time, and the reason they can do so is earnings growth. If earnings become stagnant, it can mean dividend increases may be in trouble.

Don't try to buy and sell stocks just to get the dividend
Wouldn't it be great if you could simply buy a stock the day before it pays its dividend, and then sell it the following day and pocket the dividend payment as profit? Unfortunately, it doesn't work that way thanks to how dividend payouts operate.

To appreciate why this misguided strategy should be avoided, it's important to understand the concept of the ex-dividend date. When a company declares a dividend, it announces a date, known as the ex-dividend date. Before this date, the dividend amount is still included in the stock price, and investors who buy shares before this date are entitled to the dividend. After the ex-dividend date, the stock trades without the dividend factored into its price.

For example, Verizon trades for $46.16 as of this writing, and is set to pay out a quarterly dividend of $0.565 with an ex-dividend date of October 7. So, if I buy Verizon stock on or before October 6, I'll be entitled to receive the dividend payment if I hold my shares until after that date. However, the share price will drop by roughly the amount of the dividend on the morning of October 7, since the shares are no longer trading with the dividend as part of their intrinsic value.

Not only does this strategy result in zero profit mathematically, but you'll end up paying brokerage commissions twice in order to execute the trade. There's no such thing as a free lunch in the stock market, and that's especially true with dividend stocks.

In short, the best way to invest in dividend stocks is to buy companies with a strong history of dividend increases and hold on to them for the long haul in tax-advantaged accounts. The basic theme here is that is a certain dividend stock or investment strategy seems too good to be true, it probably is. However, slow and steady accumulation of high-quality dividend stocks can make you a millionaire.

Matthew Frankel owns shares of Berkshire Hathaway, Google (C shares), Qualcomm, and Transocean. The Motley Fool owns and recommends Berkshire Hathaway, Google (A shares), Google (C shares), and Qualcomm. The Motley Fool owns shares of ExxonMobil. The Motley Fool recommends Verizon Communications. 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.