Dividend stocks: What they are and how to invest in them

Last updated on April 13, 2023, and last reviewed by an expert on January 14, 2022.

Adividend stock is a publicly traded company that regularly shares profits with shareholders through dividends. These companies tend to be both consistently profitable and committed to paying dividends for the foreseeable future.

While perhaps less exciting than chasing the latest high-flyer in the stock market, dividends can account for a significant portion of investors’ total return over time.

How dividend stocks work

In order to collect dividends on a stock, you simply need to own shares in the company through a brokerage account or a retirement plan such as an IRA. When the dividends are paid, the cash will automatically be deposited into your account.

Companies can choose to pay dividends for a number of reasons, but typically it’s a way of sharing the firm’s profits with its owners, or shareholders. Companies may also look to pay dividends if they don’t have enough business opportunities to reinvest the cash themselves.

Dividends are usually paid quarterly, but other schedules are also possible. Special dividends are one-time payments that should not be counted on to reoccur.

A company’s board of directors will approve its dividend policy and announce its plans to investors through a press release or a filing with the Securities and Exchange Commission.

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Investors need to be aware of some key dates:

Announcement date: This is the day the company announces its dividend plans.
Record date: Investors who are recorded as shareholders as of this day will receive the dividend payment.
Ex-dividend date: This is the day when shareholders who purchase the stock will no longer receive the next dividend payment.
Payment date: This is the day investors will receive the dividend payment.

What are the Dividend Aristocrats?

The Dividend Aristocrats refers to a group of companies from the S&P 500 that have increased dividends per share for at least 25 consecutive years. The S&P 500 Dividend Aristocrats ETF (NOBL) allows investors to easily purchase these companies that have consistently rewarded shareholders.

To be included in the dividend aristocrat group, certain criteria must be met:

How to invest in dividend stocks

Oil titan John D. Rockefeller Sr. once said that seeing his dividends come in were the only thing that gave him pleasure. Want to find out for yourself what Rockefeller was referring to? You’ll need to buy shares in companies, mutual funds or ETFs that pay dividends.

Individual companies: One way to start receiving dividends is to buy stock in a company that pays them. Many companies pay dividends and several have long histories of raising payouts annually. For example, Walmart announced in February 2021 that it was raising its annual dividend for the 48th consecutive year. But you’ll want to be confident in the strength and durability of the company before planning on future dividends.

A company’s dividend yield can be calculated by taking the annual per-share dividend and dividing it by the price of the stock. This percentage, or yield, can be used to compare across different companies, mutual funds or ETFs and help you determine where to get the most for your money.

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High-yield mutual funds and ETFs: If you’re looking for a more diversified approach, funds and ETFs with high dividend yields can be an attractive option. These funds will tend to hold companies with higher dividend yields than average and can be a way to generate higher income than a typical portfolio. The Vanguard High Dividend Yield ETF holds consistent dividend payers like JPMorgan Chase, Johnson & Johnson and Home Depot and comes with annual expenses of just 0.06 percent.

Dividend-appreciation funds and ETFs: This approach will typically include companies that have a history of increasing dividend payments over time. While the yield will likely be lower than funds that focus solely on high payouts, the dividend growers may see more stock price appreciation over the long term based on higher earnings growth rates. Funds focused on dividend growth will often hold companies such as Microsoft, Walmart, Visa or even Apple.

Dividends can account for a meaningful portion of investors’ total return, which includes both income and price appreciation. Since 1970, reinvested dividends accounted for 84 percent of the total return of the S&P 500 index, according to a recent study by Hartford Funds.

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Things to watch out for

Taxes: It’s important to remember that dividend income is typically taxed at ordinary income rates if the shares are held in taxable brokerage accounts. To avoid this, you might consider owning the shares through a tax-advantaged account like a traditional or Roth IRA.

Dividends can be cut: Dividends are not guaranteed and sometimes companies are forced to cut them or eliminate them entirely due to financial difficulty. That’s why you need to watch out when a company pays a very high dividend. Sometimes that high yield really is too good to be true, and the high yield may be a signal that investors expect the company to cut the payout.

But owning a diversified group of companies through an index fund can be a great way to avoid the risk of picking the wrong company. In the past 50 years, the only meaningful decline in dividends per share of the S&P 500 index came during the financial crisis of 2008 and 2009 when many banks were forced to cut their payouts. Dividends fell 21 percent during that time frame, but have since surpassed the prior peak by a wide margin.

Rising interest rates: When rates go up, it could also pose a risk to funds and ETFs with high dividend yields. As rates rise, investors who have purchased dividend funds to boost their income may rotate out of high-yield stocks toward bonds or other assets, causing stock prices to fall.

How are dividend stocks taxed?

The way dividend stocks are taxed will depend on the type of account you hold them in. If you hold the stocks or dividend-paying funds in an individual or joint account, you’ll pay taxes on the dividends you receive as well as on any realized gains. Dividends are typically taxed at the same rate as ordinary income, while the rate on capital gains will depend on how long you’ve held the asset and your income level.

If you hold dividend stocks or funds in tax-advantaged accounts such as a traditional or Roth IRA, you won’t pay any taxes on the dividends or your realized gains.

Dividend stock investing strategies

For those interested in dividend-investing strategies there are generally two approaches to consider:

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Dividend yield: The first option is to purchase stocks or funds that offer high current dividend yields. These companies may be undervalued or could be facing some business challenges that have depressed their stock price and pushed the dividend yield higher. In some cases the dividend could be cut or even eliminated to address financial difficulties.
Dividend growth: Another option is to own companies or funds that have consistently increased their dividends over time. These stocks will usually have a lower yield than high-dividend stocks, but they usually have healthy underlying businesses with a history of increasing earnings.

Dividend stocks vs. dividend funds

One key decision investors will have to make is whether they’d like to purchase dividend stocks or dividend funds. A dividend stock is just a publicly traded company that pays a dividend, while a dividend-focused mutual fund or ETF is a basket of several dividend-paying stocks. The main benefit of taking the fund approach is that you’ll spread your risk across a larger number of companies versus just picking a handful of individual stocks on your own. This is the benefit of diversification.

On the other hand, if you’re a more experienced investor and like doing research on companies, you might be able to achieve higher returns by concentrating your investments in just a few companies that you know and understand well. Some high-dividend stocks may be facing a particular business challenge and researching that issue thoroughly can help identify an attractive investment. But for most investors, dividend funds should be a safer approach.

The bottom line

Dividends can have a big impact on your portfolio over time. They can help generate income during retirement or earlier and can also be reinvested to increase your total investment return. Consider owning dividend-paying companies through a low-cost fund or ETF in a tax-advantaged account as part of your long-term investment plan.