Making Money from Dividends
One of the basic fundamentals of good investing involves making money from dividend-paying stocks. Too often, however, new investors don't fully understand dividends, how dividends work, and how dividend stocks can add a stream of income to their bank account. The following overview describes the general principles behind making money from these types of investments.
Why Use Dividends for Income?
Companies have money to fund dividend payments once they earn a profit. The Board of Directors, elected by the stockholders, or owners, has a meeting and listens to management's recommendation about how much of the profit should be reinvested in growth, how much should be used to pay down debt, how much should be used to buy back stock, and how much should be distributed out to the owners or shareholders. The last part, the money distributed to the owners, is called a dividend.
The process of making money through dividend investing involves searching for companies that have a good chance of increasing their dividend payments year after year, causing more money to flow into your bank account. As sales and profits grow, so too does the dividend, at least in some cases.
If you earn dividend income outside of a retirement account, your dividends can be reinvested, used to pay household bills, send a child to college, start a business, pay for vacations, or given to charity.
The more shares you own of high-quality dividend stocks, the more money you make from dividends. In effect, dividend investors collect this specific type of investment over time like a child might collect baseball cards.
Done correctly, the dividend investor's net worth and household income continue to expand and grow as time passes. Over 30, 40, 50 years or longer, it would be possible to earn a substantial amount of money each year, from dividends alone.
To see how this works, imagine a young man named Anthony. He's 18 years old and has just joined the workforce. He decides that he wants to start making money from dividend stocks so he begins investing whatever he can afford into shares of high quality, blue-chip companies that show healthy growth, strong balance sheets, and which have a history of increasing the dividend paid to stockholders over time.
He wants to avoid taxes so he opens a Roth IRA to hold his dividend stocks, making sure to get the maximum tax advantage by meeting the Roth IRA contribution limit each year.
That means Anthony can save and invest up to $5,500 annually, or $458.33 per month. As long as he follows the rules of Roth IRA investing, he will never pay a single penny in taxes on the money he makes in the account.
Anthony manages to grow his investments at 8 percent for the next 50 years. By the time he reaches 68 years old and decides to retire, his portfolio has grown to a staggering $3,155,735.86.
If he invests conservatively and chooses stocks with an average dividend yield of 3 percent, he would be collecting $94,672.08 in cash dividends each year. Remember, he doesn't have to pay a single penny in taxes on this income because he holds the stocks within his Roth IRA account.
Important Things to Consider When Learning Dividend Investing
Making money from dividend investing involves a handful of key considerations. These include:
- The dividend yield a stock offers at the time of purchase.
- The rate of growth in the company's profit, which might be used to project future dividend increases.
- The health of the company's balance sheet. Investing in companies with tons of debt and declining sales presents a real risk, no matter how large the dividend may appear.
- The current dividend tax laws.
If you don't want to select individual dividend stocks but still want to try your hand at making money with dividend investing, you might consider a low-cost index fund that specializes in dividend-paying companies. One famous dividend index is the S&P 500 Dividend Aristocrats Index, which tracks large, high-quality blue-chip stocks in the S&P 500 that have successfully raised their dividend every year for the past 25 years.
You can also investigate dividend-focused exchange traded funds (ETFs) such as the iShares Dow Jones Select Dividend Index or the Vanguard Dividend Appreciation ETF. Be sure to read the mutual fund prospectus for any potential investment to make sure you understand how the stocks held in the fund are chosen and determine whether the risks are right for you and your financial situation.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.