Dividend Paying Stocks
- Last Updated: Wednesday, 20 January 2021
When interest rates are low, retirees and other investors turn to dividend paying stocks to provide them with a reliable source of income. In fact, investing in companies paying high dividend yields is often viewed as the “sensible” or “rainy day” approach to creating an investment portfolio.
Companies Paying High Dividends
Common stocks paying high dividends are often associated with utilities and financial institutions. If we use electric utilities as the example, we might conclude that high dividends were the result of limited internal investment opportunities. Let’s take a closer look at this example, because it helps us understand why companies offer dividends to their stockholders in the first place.
The Chief Financial Officer of an electric utility has a choice to make at the end of each earnings period. She can use profits to pay down debt, or to repurchase shares of common stock, thereby reducing the financial leverage of the company. She can also use profits to reinvest in the company itself. This strategy is frequently used in industries with above average growth potential. Finally, she can return earnings to shareholders in the form of dividends.
In reality, the CFO is constantly evaluating opportunities to use earnings in a way that provides the greatest benefits to shareholders. But often the alternatives are limited, especially for large companies in mature industries.
For example, most electric utilities have a franchise territory. Companies that are in well-developed states may not have a lot of opportunity to grow their business; they are limited by the geographic size of their franchise territory. In this example, the CFO may decide to return a larger proportion of earnings to shareholders in the form of dividends.
Stocks of the Dow
Now that we’ve explained why a company might offer shareholders a high dividend yield, let’s take a closer look at the yields of some blue chip stocks. We used a stock screener to pull a list of companies that are members of the Dow Jones Industrials that are paying dividends in excess of 3.50% (October 2019).
|Stock Symbol||Company Name||Dividend Yield|
|IBM||International Business Machines||5.52%|
If we look at the smaller set of the Dow Jones Utilities, those stocks paying dividends in excess of 3.50% include:
|Stock Symbol||Company Name||Dividend Yield|
|DUK||Duke Energy Corporation||4.01%|
Analyzing the above information reveals that four of the thirty stocks (11.1%) in the Dow Jones Industrials were paying dividends of 3.50% or higher. Of the 15 stocks in the Utility Index, five of these (33.3%) were paying dividends in excess of 3.50%. The theory behind utilities paying relatively high dividends holds true in the data.
Dividends and Taxes
Changes to tax code make the payment of dividends to investors even more attractive. That’s because qualified dividends are taxed at a lower rate than ordinary dividends as explained below. This has resulted in even higher payouts from companies already providing investors with good yields.
Ordinary versus Qualified Dividends
Ordinary dividends are paid out of the earnings and profits of a company. Unless they meet the standard test for qualified dividends they are federally taxable as ordinary income. Qualified dividends are those received in tax years after 2002, subject to the same federal income tax rate as net capital gains. The American Taxpayer Relief Act of 2012 made several important changes to the treatment of long-term capital gains. Individuals in the 10% and 15% federal income tax brackets pay 0%, while those in the 39.6% bracket pay 20%; all other taxpayers owe 15%. Short-term capital gains are taxed at an individual’s “normal” incremental tax rate.
Capital Gains Eligibility Rules
For stock dividends to be eligible for capital gains rates, they must meet all of the following requirements:
- They must be paid by a U.S. corporation or a qualified foreign corporation.
- They cannot be those that are specifically excluded from qualified dividends (includes capital gains, dividends from savings bank accounts and those paid on ESOPs).
- Stock holding periods must be met. For common stock, the holding period is more than 60 days of a 121-day timeline (60 days before and 60 days after the ex-dividend date). Preferred stock must be held for more than 90 days of a 181-day timeline (90 days before and 90 days after the stock goes ex-dividend).
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