What are dividends?
Companies distribute profits when they make earnings. They use a portion of these profits to send money to people who have invested in them. The board of directors meets to hear from the company’s leaders who propose the amount of profits to be allocated for growth. A portion of the remaining amount is paid to shareholders as dividends.
Why use dividends as income?
You can reinvest your dividends. You can also use them to pay household bills, send a child to college, start a business, fund vacations, or donate to charity. The more good dividend-paying stocks you own, the greater your chances of earning more money. Dividend investors accumulate this specific type of investment over time.
Example of dividend investment
Let’s say Anthony is 18 years old and has just gotten a job. He decides he wants to start earning money from stocks, so he begins investing. He chooses shares of large, reliable companies. He looks for companies that show healthy growth and have strong financial statements and a consistent history of increasing the dividends they pay over time.
He wants to avoid taxes, so he opens a Roth IRA. Anthony can contribute up to $6,000 to this account each year since he is under 50, which is the limit set by the IRS until 2022.
This decision gives him a significant advantage in tax planning because he will not pay any taxes on the earnings he makes in this account as long as he follows the Roth IRA rules. Contributions are made after tax deductions and cannot be deducted from income, so any money he withdraws will be tax-free after five years.
Anthony is able to grow his money by 8% over the next 50 years. Thanks to compound interest, his portfolio grows to over $3 million by the time he turns 68 and decides to retire.
He can withdraw about $96,000 annually if he invests wisely and chooses stocks that provide an average dividend yield of at least 3%. That’s cash in his pocket. And he won’t have to pay any taxes on this income as he keeps the stocks within his Roth IRA.
Important considerations
Making money from dividend-paying stocks involves a few key factors: the dividend yield offered by the stocks at the time you buy them, the company’s earnings growth rate, which can be used to project future dividend increases, the company’s financial statement health, and current tax laws related to dividends.
In 2013, the Net Investment Income Tax was implemented. This tax collects 3.8% of your net earnings, depending on how much you earn and your tax status. It applies to those who earn more than $200,000 per year filing as single or head of household, or more than $250,000 per year if married and filing jointly (if married filing separately, the income threshold is $125,000). This may impact your final balance if the threshold applies to you.
It is best to consider a low-cost index fund that focuses on dividend-paying companies. An index fund is an exchange-traded fund (ETF) or mutual fund that tracks a specific market index. You don’t have to select each stock yourself with this option, but you can try to make money by investing in dividends.
An example of such an index is the S&P 500 Dividend Aristocrats. It tracks high-quality large-cap stocks in the S&P 500 that have raised their dividends every year for the past 25 years.
You can
Also consider index funds focused on distributions, such as the iShares Select Dividend ETF or the Vanguard Dividend Appreciation ETF.
Make sure to read the mutual fund prospectus before investing. This prospectus tells you how the stocks in the fund are selected. It will help you determine if the risks are appropriate for your situation.
Frequently Asked Questions
How often are distributions paid?
Most companies pay distributions quarterly, but some may choose to pay monthly, annually, or even semi-annually. You can check the company’s investor relations page for distribution payment dates.
How are distributions calculated?
Distributions are paid on a per-share basis. Multiply the distribution by the number of shares you own to calculate the expected payment. For example, you would receive a distribution payment of $29 if you own 10 shares in a company that pays $2.90 per share as a distribution.
How do I know which stocks pay distributions?
The company’s investor relations page, along with its information on its listed stock exchange (NASDAQ, NYSE, etc.), includes information about distributions. Generally, you should look at larger, more established companies if you’re interested in dividend-paying stocks.
Source: https://www.thebalancemoney.com/making-money-from-dividends-357434
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