How to Invest in Dividend Stocks and Create Income

Dividend Investing, Investing Strategies, Real Estate Investment Trusts (REITs)
how to invest in dividend stocks: old man and woman holding hands while walking

Living off dividends in retirement is a goal shared by many investors. Dividend investing can help you achieve your income goals through dividend payouts and capital appreciation over time. Stable dividend cash flow will allow you to replace your regular income, maintain a reasonable quality of life in retirement, and sleep well at night.

A well-maintained investment portfolio can help you achieve your financial goals regardless of the volatility in the stock market. In this article, we will discuss how to set your investment goals, review what types of dividend stocks exist, and look into what tax rates you should expect. By the end of the article, you will know how to invest in dividend stocks to create a passive income.

Overview of How to Invest in Dividend Stocks

Dividend investing is a well-known investment strategy, with the goal of creating passive income. Good dividend stocks perfectly match retirement investor dreams: They can cover monthly expenses, grow faster than inflation, and are usually safer than growth stocks. As investors get closer to retirement, they tend to increase the share of dividend stocks within their portfolio. 

There are so many types of dividend securities that combine growth, high dividend yield, and safety. For example, many individual stocks, closed-end funds (CEFs), exchange-traded funds (ETFs), preferred stocks, and real estate investment trusts (REITs) pay dividends. Unlike bonds, they offer higher returns and stock price appreciation.

Where to Start Investing in Dividend Stocks

To start the planning, you need to know what portion of your savings you want to invest (your investment portfolio size) and what portion to keep in cash. Also, you need to estimate your living expenses during retirement (your annual budget). Then, by dividing the annual budget by the investment portfolio size, you will get an estimated return that you need to achieve.

For example, if you saved $500,000 and expect to spend $50,000 per year during retirement, you need to achieve a 10% return. 

Also take into account:

  • Other sources of income: Do take into consideration other income sources — like a pension or Social Security benefits. For example, if you plan to receive a pension or Social Security benefit, you may need to generate less passive income.
  • Taxes: To be more conservative, you may want to add an extra cushion for taxes. We will review tax rates for different investment types below.

With the goal in mind, the next step for an income investor is to open a brokerage account and create a diversified portfolio by selecting and investing in various securities.

If you are generating additional income above your expense needs, you should also consider compounding your returns by setting up a dividend reinvestment plan (DRIP) within your brokerage account. This allows you to automatically reinvest dividends into new shares of stock.

Where to Find Dividend Stocks

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There are many types of dividend securities. Many pay monthly dividends, which can help you cover your monthly expenses more consistently, and many pay quarterly or annual dividends. In addition, good-quality dividend stocks have dividend growth and strong liquidity — an investment metric showing how quickly investors can convert the share price into cash.

As a next step in the “how to invest in dividend stocks” journey, let’s review different types of securities that can help you earn dividend income:

  • Real estate investment trusts (REITs): These trusts generate passive income from real estate rentals and pay out the company’s earnings as dividends. For further diversification, investors can select a mix of local and global properties, industries, and property types.
  • Preferred shares: Companies issue preferred shares as a debt mechanism. To borrow the capital, they issue the preferred shares and pay dividends, and stockholders, in turn, benefit from higher yields than are paid by common shares. The preferred shareholders have a right to receive dividend payments from the company’s earnings before common stock shareholders.
  • Exchange-traded funds (ETFs): These funds can track the performance of an index, sector, commodity, or a mix of other securities. Some ETFs consist of dividend-paying stocks that track a dividend index, and some of them also have a reinvesting option. For example, the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) is an ETF that tracks the S&P 500 Index. This means it follows the performance of the 500 largest publicly traded companies, including Amazon, Microsoft, and Facebook. 
  • Individual stocks (ordinary shares): Investors can find many companies that pay dividends and give their shareholders rights to vote and own a stake in the company. The most well-known individual companies that pay dividends are called the Dividend Aristocrats. These are cash-generating companies with extraordinary track records and market value above $3 billion. They increased their dividend payments in the last 25-plus consecutive years despite market volatility.
  • Mutual funds: These funds are required to pass through profits to their shareholders in the form of dividends. Some mutual funds invest for growth and some for value. When investing for value, funds purchase high-dividend stocks and high-coupon bonds to ensure high dividend yield. 
  • Closed-end funds (CEFs): Fund managers actively manage CEFs. They are looking for the best additions to the existing portfolio to achieve a high dividend yield while keeping the risk low. These funds focus on long-term growth instead of short-term speculation.

How Are Dividends Taxed?

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There is no need to do complex tax calculations yourself, as your broker will send you a detailed tax form called a 1099-DIV. At the same time, you need to have an estimate in mind to be prepared to pay your taxes and readjust your investment goals. Keep in mind that the dividends you receive as part of a 401(k) plan or a traditional IRA retirement plan are tax-free while they are in the account. But the taxes need to be paid when you cash them out.

Federal tax rates are driven by dividend type: Some dividends can be considered qualified and some unqualified.

Qualified Dividends

Qualified dividends are taxed at the long-term capital gains rate. This preferential rate can be 0%, 15%, or 20%, depending on your tax bracket. For example, if you are single and make less than $40,400 or are married and make less than $80,800 in 2021, you will benefit from a 0% capital gain rate. If you are single and earn up to $445,850, or $501,600 if married, you will pay taxes at a 15% rate. Above that, you will pay taxes at a 20% rate.

Also, different securities may have their own rules. ETF, preferred share, and common stock dividends can be classified as qualified if an investor met the minimum holding period. For example, you must own the ETF or common stock for over 60 days before the ex-dividend date, and you must hold a preferred share for more than 90 days before the ex-dividend date.

Ordinary (Unqualified) Dividends

If you didn’t meet the minimum holding period, the dividends will be taxed at your income tax rate. Also, income from many mutual funds and REITs comes in the form of non-qualified dividends.

The income tax rate is usually higher than the long-term capital gains rate. For example, the lowest rate is 10% for individuals with an income of $9,950 or less, or $19,900 for married couples filing jointly.

When Will You Pay State Taxes on Dividends?

The state taxes that you will pay on your dividend income depend on where you reside. The best states for retirees are Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming because they do not tax dividends. If you reside in California, Hawaii, New York, New Jersey, the District of Columbia, Oregon, Minnesota, or Vermont, then prepare to pay additional taxes to your state. 

For example, if you reside in the state of California and expect to spend $70,000 from your dividend distributions at your retirement, you will pay $2,581.60 in taxes plus 9.3% for the amount over $58,634, or $3,639 in total to the state.

Invest in Dividend Stocks to Create Your Retirement Income

You learned about investment return goals, what types of securities to look into, and how the dividends are taxed. Now you know how to invest in dividend stocks and create a sustainable passive income. 

To excel in dividend investing and learn more about what dividend stocks to buy to create an all-weather portfolio, subscribe to Investors Alley’s Dividend Hunter newsletter.

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