Previously, we’ve talked about passive income ideas to boost your earnings. In terms of growing your income, dividend stocks are one of the best time tested strategies.

In this post, we’ll take a deeper dive into how dividends and dividend investing build up your portfolio, both before and during retirement.

Understanding How Dividends Work

I’m a big fan of high quality dividend stocks and have owned these stocks as part of my core portfolio for many years. Having over fifty percent of my stock portfolio made up of dividend-paying stocks, they continue to throw off additional income for me year in and year out.

So what are dividend stocks, and how do dividends work?

Dividends are typically cash payments made by a company to its shareholders from a portion of its profits. 

When a company generates earnings, it has the option to reinvest those profits back into the business, pay down debt, repurchase shares, or distribute a portion of the profits to shareholders in the form of dividends.

Essentially, a dividend is a payment that a company makes to its shareholders out of the profits it earns for the year.  

Companies that consistently pay out dividends tend to be more established and mature businesses with steady cash flows and a track record of profitability.

The Ex-dividend Date and Price Adjustment

When a company declares a dividend, it sets aside funds from its cash reserves to pay its shareholders.

The ex-dividend date is the day on which a stock or ETF begins trading without the right to receive the next scheduled dividend payment. This means that if you buy shares on or after the ex-dividend date, you won’t receive the upcoming dividend.

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On the ex-dividend date, the stock or ETF price typically opens lower than the previous day’s closing price. This is because the market adjusts for the dividend payment that will be made to existing shareholders. 

For example, suppose a stock is trading at $100 per share. The company declares a $2 dividend per share. On the ex-dividend date, the stock price might open around $98. This adjusted price reflects the $2 dividend reduction.

The Dividend Yield

Another key metric to evaluate dividend stocks is the dividend yield. This is calculated as the annual dividend per share divided by the current share price.

The yield represents the income return you receive for every dollar invested in the stock. For instance, if a stock trades at $100 per share and pays an annual dividend of $3 per share, its dividend yield would be 3%.

This means you’ll earn 3 cents in dividend income for each dollar invested at that $100 share price.

Note that dividend yield is inversely proportional to the share price. This means that an apparently rising yield may actually be due to a declining share price rather than an increase in the dividend itself.

The Dividend Aristocrats

Some of the most well known companies that pay dividends are a group of companies in the S&P 500 index known as the Dividend Aristocrats. These companies have raised their dividend payouts to shareholders every year for at least 25 consecutive years.

There are currently 68 Dividend Aristocrat companies across various sectors like consumer staples, industrials, healthcare, and financials.

To be a Dividend Aristocrat, companies must be S&P 500 companies, and in order to be S&P 500 companies, most companies need to have a market cap of at least $13 to 14 billion to be considered for addition to the index.

Some well known companies that are part of the Dividend Aristocrats include names such as Realty Income Corp, Johnson & Johnson, 3M, Coca-Cola Co, Procter & Gamble Co, Exxon Mobil, and PepsiCo Inc.

The Power of Compounding Dividends

From January 2000 to January 2020, the S&P 500 index returned 129% without accounting for dividends. But if ​​you had reinvested all of the dividends paid by the stocks in the index during this time period, your return would be 235%.

The effects of dividend compounding get amplified even more when you factor in companies raising their payouts over time and your ability to keep investing new money. 

When you reinvest the cash dividends received back into additional shares of that same stock, you’re using your dividends to accumulate more shares without having to invest additional cash upfront.

In essence, you’re compounding in two ways – growing your overall portfolio balance while also accumulating more shares, which produces an increasing dividend income stream.

As you acquire more shares, you’ll receive even larger dividend payments on the increased stake. Those larger dividend payments can then be reinvested to purchase additional shares, which in turn generate even more dividends.

Let’s say you start with $1,000 and earn a 5% return from the stock’s dividend in year one, which is $50.

You reinvest that $50 to buy more shares, and in year two, the 5% return from your dividend will be calculated on a slightly higher balance of $1,050 due to the previous year’s gains. So a 5% return now equals $52.50 instead of just $50.

That $2.50 difference may seem small at first, but over time, it will start adding up quickly. Apply this concept to larger portfolio values, and the effect becomes immense over 20, 30, or 40 years.

It’s this cycle that allows you to exponentially increase your ownership stake in the company over several decades through gradual stock purchases funded by the dividends themselves.  

The compounding math works in your favor – not just compounding the dividend income, but also compounding any gains in the stock’s price appreciation over many years.

Let’s look at a simple example using a hypothetical portfolio. We’ll ignore the impact of taxes (more on that below) and transaction costs.

Let’s assume you and your spouse each own a portfolio where each of you achieves a steady 3% annual average dividend yield. Each of your portfolios also achieves a steady 5% annual growth rate (or capital gain).

Based on these assumptions, we see the two scenarios below.

The first one is where you take the 3% in dividends received each year and reinvest 100% of it back into the portfolio. The second scenario assumes your spouse doesn’t reinvest the 3% in dividends back into the portfolio.

We can see that your portfolio with reinvested dividends is worth $135,380 more than your spouse’s when dividends are reinvested over a period of twenty-five years.

Dividend Stocks Over the Long Term

Historical market data has shown that In times of market pullbacks where the S&P 500 declines by 5% or more, investors with dividend stocks have typically felt less of the impact.

Also, the Dividend Aristocrats have historically seen smaller drawdowns during recessions versus the S&P 500. In 2008 the Dividend Aristocrats Index declined 22%. That same year, the S&P 500 declined 38%.

There have also been instances where dividends have beaten inflation, such as in 1973, 1979, and during the early 1990s.

Here are just a few names of some widely held dividend paying stocks with a solid track record of consistently sharing profits with their shareholders for decades:

• ExxonMobil (XOM) – Current dividend yield of 3.4%.
• Chevron Corp (CVX) – Current dividend yield of 4.1%
• Coca-Cola (KO) –  Current dividend yield of 3.2%.
• Johnson & Johnson (JNJ) – Current dividend yield of 2.99%.
• Procter & Gamble (PG) – Current dividend yield of 2.3%.
• Colgate-Palmolive (CL) – Current dividend yield of 2.2%.
• Abbvie Inc (ABBV) –  Current dividend yield of 3.4%.
• McDonald’s (MCD) – Current dividend yield of 2.3% and has paid a dividend every year since 1976 and has raised its dividend annually for over 45 consecutive years.

Even some big tech companies pay dividends, such as Microsoft, Apple, Oracle and Broadcam. Also, Meta just recently announced they’ll begin paying dividends for the first time.

How to Assess Dividend Stocks

When assessing dividend stocks, some important aspects to evaluate are the company’s financial health and dividend sustainability. Here are some key metrics:

Dividend payout ratio: This is the percentage of a company’s earnings paid out as dividends. Here’s how it’s calculated: Dividend Payout Ratio = Total Annual Dividends per Share / Earnings Per Share.

A payout ratio below 50% is generally considered healthy, and indicates that the company can afford the dividend while retaining funds for growth.

Ratios over 50% could be a signal that the dividend is unsustainable over the long term. Compare a stock’s payout ratio to its industry peers to gauge whether it is reasonable relative to others in the same sector.

Dividend growth rate: Companies with a consistent track record of increasing their dividends over time can offset inflation and provide a growing income stream.

Financial strength: Look at the company’s financial health by analyzing factors such as revenue and earnings growth, debt levels, cash flow, and its position within its industry.

Valuation: Just as with any stock, consider the stock’s valuation relative to its peers and its historical valuations.

In terms of the types of dividend stocks available to invest in, categories include:

Blue-chip stocks: These are large, well established companies with a strong track record of paying and increasing dividends over time (such as stocks that make up the Dividend Aristocrats).

Real Estate Investment Trusts (REITs): REITs are companies that own and operate income generating real estate properties, such as apartment buildings, shopping malls, or office complexes.

By law, REITs must distribute at least 90% of their taxable income to shareholders in the form of dividends. Realty Income Corporation (O) is a popular REIT that currently has a dividend yield of 5.9%.

Utility stocks: Companies in the utility sector, such as electric, gas, and water utilities, are often considered stable dividend payers due to their regulated nature and relatively predictable cash flows.

An example is Duke Energy Corporation (DUK) which has a current dividend yield of 4.3%.

High-yield dividend stocks: These are stocks that have higher than average dividend yields, typically above 4% or higher. Be careful when looking at high-yield stocks because they can come with higher risks.

For example, AT&T Inc (T) has traditionally offered investors a high dividend yield  (its current dividend yield is 6.5%).

But in terms of the stock’s return, it’s down 35% over the past ten years.

Another cautionary high-yield stock is Altria Group, Inc (MO) which has a current dividend yield of 8.9%. But the stock is down 23% over the past five years. As an investor, you should focus on the highest quality stocks by evaluating them based on the above metrics.

Investing in Dividend Stocks ETFs

Another strategy to invest in dividend stocks is investing in dividend stocks exchange traded funds (ETFs).

Rather than picking and choosing individual dividend stocks to invest in, dividend stocks ETFs are a more passive investing approach because these ETFs hold a well-rounded basket of many dividend stocks that track the performance of an index.

One of the advantages of ETFs is diversification, which helps spread risk. If one company fails or cuts its dividends, the impact on your overall investment is minimal.

Dividend Aristocrats ETFs

If you’re looking to gain exposure to the dividend aristocrats, but don’t want to spend the time and money to buy some or all of those individual stocks, consider buying an ETF that owns dividend raising stocks instead.

The ProShares S&P 500 Dividend Aristocrats ETF (NOBL) is the only one that strictly tracks the official S&P 500 dividend aristocrats. There are also other dividend ETFs that own similar groups of stocks that consistently raise their dividends over time.

Another benefit of owning ETFs is that it’s accessible for most investors. Buying some high dividend stocks can require more capital, so you can either own only a few shares or, if you own more shares, this can make your portfolio too concentrated.

With an ETF, you can buy as little as one share which allows you to invest small amounts.

As a side note, you can also invest in mutual funds that own dividend stocks. Some of these funds are actively managed and attempt to build a portfolio of the best dividend stocks.

But this active management comes with the trade off of a much higher expense ratio. On top of that, most actively managed funds underperform their indexes.

How Dividends Are Taxed

Dividends, just like other forms of income, are subject to tax. How dividends are taxed depends on a few factors.

The tax rate on qualified dividends is 0%, 15%, or 20%, depending on taxable income and filing status.

Source: Internal Revenue Service

Although most dividends qualify for the lower tax rates, some dividends are classified as “ordinary” or non-qualified dividends and are taxed at your marginal tax rate.

The tax rate on nonqualified dividends follows ordinary income tax rates and brackets (rates of 10% to 37% or more, although an additional 3.8% tax is imposed on certain investment income for the highest earner).

For preferential tax treatment for qualified dividends, you’ll need to adhere to specific holding time criteria: hold the stock for a duration exceeding 60 days within a 121-day period that commences 60 days prior to the ex-dividend date.

That means you could pay a lower dividend tax rate just by holding your investments for the 61-day minimum period. In addition, dividends by foreign companies that are traded through American Depositary Receipts (ADRs) or on U.S. markets also be considered qualified.

Certain types of stocks are structured to pay high dividend yields and may come with higher tax obligations due to their corporate structures.

The two most common are real estate investment trusts, also known as REITs, and master limited partnerships, also known as MLPs. Money market funds and other cash-like instruments also pay ordinary dividends.

Another strategy to leverage dividend stocks is to own them in tax-advantaged accounts. Taxes on dividends don’t apply if your dividend stocks are held in tax-advantaged retirement accounts, such as a traditional IRA or Roth IRA.

Note that income from MLPs can still trigger tax liability, even when held within an IRA account. 

Also, each state has its own tax laws regarding dividend income.

For instance, states like California, New York, and New Jersey are known for higher tax rates on income, including dividends. But states like Florida, Texas, and Nevada don’t impose state income tax.

Assessing Risks

When searching for dividend yields, you’ll want to carefully analyze the stock’s fundamentals behind high dividend yields, rather than simply chasing those with the highest current yield.

Here are some areas to pay attention to:

Dividend cuts or suspensions: Companies may reduce or eliminate their dividend payments if their financial performance deteriorates, which can impact the income stream and the stock price.

Concentration risk: Overconcentration in a particular sector or industry can increase portfolio risk if that sector or industry experiences a downturn.

Interest rate risk: Rising interest rates can make dividend paying stocks less attractive relative to fixed-income investments and can put pressure on stock prices.

Reinvestment risk: If dividend payments are reinvested, this is the risk that the reinvestment opportunities may be less attractive than they were when the initial investment was made.

As you’ve probably heard, one of the best ways to hedge risk is to have a well diversified portfolio. In addition, you’ll want to regularly review and rebalance your holdings.

Final Thoughts

Building a portfolio with dividend-paying stocks can be a powerful way to compound your wealth before and post retirement. The key is to invest in high quality companies that can sustain and grow their dividend payments consistently.

Then, be patient and let compounding do most of the work for you over decades.

The best part is that if you’re able to grow your investment portfolio to a sizable amount over time, dividend investing can eventually make up a good portion, if not all of your entire passive income strategy.

Dividend Investing Terms for Reference

Here are some basic terms to keep in mind when it comes to dividend investing:

Record date: When the company checks and records information on which shareholders are eligible for a dividend payout.

Dividend yield: This is the annual dividend per share; it’s computed by dividing the upcoming dividend by the share price.

Ex-dividend date: This is a cut-off date where if an investor buys shares on or after this date, they won’t receive the upcoming scheduled dividend.

Declaration date: This is when a company’s board of directors formally announces a dividend payment. On the declaration date, shareholders can also learn about the dividend’s amount, ex-dividend date, and payment date.

Payment date: The day on which declared dividends are distributed. If it’s a cash dividend, the company sends payments to shareholder’s brokerage accounts.

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