Introduction To Dividends: Doing Your Homework And Taxes
Similar to any other investments, it is important to perform due diligence prior to making any dividend-related decisions. There are several factors to consider when researching and selecting dividend stocks, including the dividend yield, dividend coverage ratio and the company's history of dividends.
As mentioned previously in this tutorial, the dividend yield shows how much a company pays in dividends each year relative to its share price. It is calculated by dividing the annual dividends per share by the price per share.
It would make sense that the higher the dividend yield, the better the investment, but this financial ratio can be deceptive. Remember that this ratio increases as share prices drop. A dividend yield that is unusually higher than other stocks in the same industry may indicate that the stock's price may drop, or that future dividends will be cut or eliminated. This can spell double-trouble for investors who will lose money both on the falling stock price and the loss of any future dividend income. In general, many investors focus on stocks whose dividend yields fall in the 2 to 5% range - the average range of S&P 500 stocks over the past six decades.
Dividend Coverage Ratio
The ratio between a company's earnings and its net dividend to shareholders is known as dividend coverage. This ratio helps investors measure if a company's earnings are sufficient to cover its dividend obligations. Dividend coverage is calculated by dividing earnings per share by the dividend per share:
|Figure 4: How to calculate dividend coverage.|
For example, a company that has earnings per share of $7 and pays a dividend of 2.5 would have dividend coverage of 2.8 ($7 ÷ 2.5 = 2.8).
In general, a coverage ratio of 2 or 3 shows adequate coverage and that the company can afford to pay a dividend. If the ratio falls below 2, it could indicate that a dividend cut is on the horizon. If the ratio falls below 1, the company is likely using last year's retained earnings to cover this year's dividend. A ratio that is high, such as greater than 5, may indicate that the company is "holding out" on investors and could have paid a larger dividend to shareholders.
Companies that boast consistent dividends, particularly if dividends increase over time, are typically financially stable and well-managed. While a good track record does not guarantee future results, a company that has performed well in the past may be less risky than one with a spotty or inconsistent history.
That said, any dividend-paying company must pay its first dividend at some point - companies with excellent fundamentals may wait (longer than investors would like them to) to begin paying dividends. Consider Microsoft (Nasdaq:MSFT), which didn't begin paying a dividend until February 2003, nearly 17 years after its March 13, 1986 initial public offering.
Online Research Tools and Screeners
Today's dividend investors have access to a growing number of print and Internet-based resources, research tools and screeners to help explore and evaluate dividend stocks. You may have to pay a small fee for "premium content" such as certain proprietary dividend ratings systems; however, much of your research can be performed at no cost to you - other than the time needed to do your homework.
Certain websites offer dividend screeners that allow you to screen dividend stocks based on a variety of inputs, such as industry/sector, market cap, price and dividend payout, dividend frequency and history or by a specified ex-dividend date range. Based on your specified inputs, the screener will search and display a list of dividend stocks that match your criteria, including information such as its ticker symbol, dividend yield, current price, annual dividend, ex-dividend date and pay date.
It is important to remember that investing in any stock - whether the company pays a dividend or not - is not a risk-free investment. In addition to researching on the front end, investors should monitor their investments and consult with qualified tax and investment professionals when necessary.
Any company that pays you a dividend of more than $10 must provide you with IRS Form 1099-DIV, Dividends and Distributions. Box 1a shows ordinary dividends, Box 1b shows qualified dividends and Box 3 shows non-dividend distributions. [Note: it is your responsibility to report all taxable dividends even if a company fails to send you this form.]
Ordinary dividends are paid out of a company's earning and profits, and are taxed as ordinary income (currently up to 35%) unless they are qualified dividends. A qualified dividend is an ordinary dividend to which capital gains tax rates apply (currently a maximum of 15%). A qualified dividend is one that:
- Is paid from a domestic (U.S.) company or a qualifying foreign company (one that is incorporated in a possession of the U.S. or that is eligible for benefits of a comprehensive income tax treaty with the U.S.);
- Is not listed with the IRS as a dividend that does not qualify or
- Has met the required dividend holding period.
If your dividends are significant, you may have to pay estimated taxes to avoid interest and/or penalties. The federal income tax is a pay-as-you-go tax, meaning that taxes must be paid as you receive income throughout the year. As an employee, your employer probably withholds income tax from your pay check; the money is sent to the IRS in your name. If you do not pay enough tax through your withholding, or if you have other forms of income that are not subject to withholding, you may have to pay estimated tax. Dividend income is one type of income for which you might have to pay estimated tax. In general, if you expect to owe tax of $1,000 of more, you should make quarterly estimated tax payments. Individuals can file Form 1040-ES, Estimated Tax for Individuals along with the appropriate estimated tax form for the state they live in. Alternatively, you may be able to submit a new Form W-4 to your employer to change your withholding allowances (so that more money is withheld each pay period).
Taxes are complicated and tax laws do change. A qualified tax specialist or CPA can help you determine your most favorable approach to taxes.
Note: The current top tax rate on qualified dividends of 15% may no longer apply if the Bush-era tax cuts expire after 2012. If these tax cuts expire, dividends will be taxed as regular income in 2013 - up to 39.6% for high-income earners. A new 3.8% tax on investment income may also apply, bringing the new maximum tax rate for dividends to 43.4%, a tax rate that many believe will ultimately make dividend-paying companies less attractive. Introduction To Dividends: Conclusion
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