WASHINGTON (Reuters) - Dividends are nice -- especially when bank accounts are paying less than 1 percent in interest. If you can buy shares of a company like General Electric , Kellogg or Waste Management and pick up an immediate yield of more than 3 percent, why wouldn't you?
Almost 70 companies in the Standard & Poors 500 Index are paying more in dividends than the 3.8 percent average yield now being offered in the bond market. That's a big deal: That's more companies beating bond yields than at any other time in the last 15 years.
Investors are increasingly on the hunt for dividends, in part because they see corporate dividends as acting both as a recession safety net and a recovery inflation hedge. If your share price goes down and your bonds lose value, at least you can cash that dividend check. And if the economy strengthens, inflation could become an issue. Dividends might help you then, too.
A diversified mix of high-yielding stocks almost always pays an inflation-beating real return.
But dividend-paying stocks aren't risk free, as anyone who once held Bank of America or Citicorp for their awesome pre-credit-crunch dividends will tell you. There are other issues as well.
Here's how to go dividend shopping with your eyes wide open.
- Understand the tax risk. It wasn't until George W. Bush-era tax legislation passed that dividends received the same favorable tax treatment as capital gains. Right now, most dividends are taxed at a maximum rate of 15 percent, the same as long-term gains. But those provisions expire on December 31. After that, dividends would again be taxed like ordinary income -- at rates as high as 39.6 percent -- if there is no new legislation to protect them. Most people expect dividends to retain tax breaks in the new year. The White House has suggested raising the top rate on dividends and capital gains to 20 percent, but nothing about taxes in this deficit-ridden mid-term election year is a sure thing. A sharp increase in taxes on dividends would produce a correspondingly sharp drop in the value of dividend-paying stocks.
- You can use dividends to create your own income stream. Using a stock screening program to cherry-pick a dozen different high-yielding companies, select your list so that at least one company pays a dividend in every month of the year. You'll get dividend checks rolling in every month. That can be a huge benefit for retirees facing monthly bills.
- You can get someone to choose for you. There's a host of dividend growth mutual funds, high-dividend mutual funds, and exchange traded funds that focus on buying entire indexes of big-dividend stocks. Some charge more and offer more nuanced company selection. The ETFs charge much smaller amounts, with 0.35 percent a year being a typical management fee. But this year, at least, the indexes have not been beating the better managers.
- Your old strategy may be faulty. For a long time, investment experts believed that the best dividend play involved buying shares in a company with a long history of increasing its dividend. But it can take decades for a fast-growing-but-low dividend to outstrip one that starts higher and grows slower.
- Be careful. A yield of 3.8 percent on a solid company is a very good deal. A yield of 9 percent or more probably signifies a company (or at least a dividend) that is in trouble. Companies that have problems do end up having to cut their dividends. That's a lesson driven home by the credit-crunched banks and by BP which canceled its dividend this year in the aftermath of its disastrous oil spill. So, don't reach out too far. And don't put all of your dividend hopes on one company, or even one industry. Buy a fund, or buy 'em by the bunch. And enjoy!
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