Investors have a long history of favoring dividend-paying stocks. For decades, blue chip stocks with high dividend yields were affectionately referred to "widow and orphan" stocks because they represented mature, established companies paying steady, reliable dividends. Utility companies and industrial conglomerates were often placed in this category. In this article, we'll go cover some of the history of dividends and show you why they're still favorable. (To keep reading on this subject, see"Widow And Orphan Stocks": Do They Still Exist?, The Power of Dividend Growth and The Importance Of Dividends.)

After the Crash
The run-up in the technology market in the late 1990s cooled the passion for dividends. With tech stocks soaring in value, investors turned away from dividends, and dividend yields fell. During the market peak in March of 2000, the dividend yield of stocks in the Standard & Poor's 500 Index dropped to 1.1%, barely a third of its historical 3% rate of return.

As a result, many companies chose to reinvest their dividends rather than pay them out or, if no suitable business-building opportunities were on the horizon, excess cash was used to fund stock repurchases. In turn, such buybacks served to pump up the value of the outstanding shares of stock.

Since tech stocks tumbled and double-digit capital gains largely disappeared, dividends have become favorable once again. The passage of the Jobs and Growth Tax Relief Reconciliation Act of 2003, which reduced the taxation on qualified dividends, helped to rekindle the romance. Prior to its passage, dividends were taxed as ordinary income, taking a significant chunk out of investors' earnings. The JGGTRA sliced those rates in half.

Dividends paid by stocks held for at least 60 days out of a 120-day period prior to the payment are taxed as long-term capital gains. That's a 5% tax rate for taxpayers in the lowest tax bracket and a 15% tax rate for investors in the highest brackets through 2008. In 2008, investors in the 10% and 15% tax brackets will pay no tax on qualified dividends. Dividend taxation was scheduled to revert to pre-JGTRA rates in 2009, but the Tax Increase Prevention and Reconciliation Act of 2005 extended the tax cuts through the end of 2010. (To keep reading about TIPRA, see TIPRA Helps Convert Your Plans And Save More.)

A Bright Future for Dividends
In today's investment environment, where there are only relatively modest capital gains expectations for stocks and low interest rates, dividends can have a significant impact on investment returns. Many economists and market prognosticators anticipate an increase in current dividend yields, which are currently below their historical averages.

Generally speaking, the fact that a company can afford to pay a dividend is viewed as a sign of economic health, as faltering companies generally have no excess cash, and if they do, they need it to keep the business running. Payment of a dividend is generally a sign that the firm's management views returning excess cash to the shareholders as the best use of the firm's profits.

When you look at the numbers, the contribution that dividends have historically made to the total return of the S&P 500 is astounding. Although the S&P was up +3,268% from 1955-2004, if you add in the impact of reinvested dividends, the total return of the index was +17,838% according to BTN Research.

Dividends and Mutual Funds
Buying dividend-paying stock is the most obvious way to tap into the income stream dividends offer, but mutual funds also provide a convenient option. Purchasing a dividend-paying fund eliminates the need to identify an individual stock and provides instant diversification, as most funds contain dozens, if not hundreds, of underlying stocks. Diversification reduces stock-specific risk because a portfolio containing multiple stocks is less affected by the fortunes of any one firm, thus increasing the reliability of the dividend income stream. Better yet, dividend-paying mutual funds don't charge a brokerage commission, so small amounts of money can be invested at multiple intervals without racking up large expenses.

Most dividend-paying mutual funds are on a quarterly payment schedule. Dividend-paying mutual funds include bond funds, taxable money market funds, and real estate investment trusts (REITS), but keep in mind that dividends from these sources are not viewed as "qualified dividends" from a taxation perspective. Bond funds and money market mutual fund earn their dividends through interest income and are therefore taxed as ordinary income. REITS pay no taxes on the income that they generate, provided they pass at least 90% of taxable income to shareholders; therefore, shareholders pay the income tax.

If taxes are a concern, mutual funds that receive dividends from equity investments (stocks) are the way to go, as they provide qualified dividends. Equity income funds, value funds and some sector funds (such as utilities) generally fit into this category, provided the fund has been held for at least 60 days prior to the ex-dividend date (or the date on which a fund's shareholders become entitled to an upcoming dividend). "Qualified Dividend Income" will be shown on the shareholder's Form 1099-DIV, which will be mailed from the fund company in late January. (To learn more about dividends, see Declaration, Ex-dividend And Record Date Defined and Dividend Facts You May Not Know.)

When to Not Buy
By law, mutual funds distribute at least 98% of their ordinary and capital gains income on an annual basis. To meet this requirement, many funds make large distributions in December. Purchasing a mutual fund just before this date can trigger an unexpected tax liability. For example, if a $1,000 fund purchase is made just prior the fund paying a 10% dividend, the shareholder would have $100 returned in the form of dividend, not only reducing the amount or principal available for investing, but triggering a tax bill on the $100 distribution.