Making money from dividends is one of the basic foundations of good investing. Too often, new investors don't really understand what dividends are, how dividends work, and how you can make money by investing in dividend stocks. To help you overcome that, I wrote an extensive special called The Complete Beginner's Guide to Dividends and Dividend Investing. But here, I want to provide a brief overview of the process of making money from these types of investments. Think of this as a two-minute course syllabus to making money by investing in stocks that pay dividends.
How Do I Make Money From Dividends?
Want to know how to make money with dividends? The short answer is this: A company earns a profit. The Board of Directors, the members of which are elected by the stockholders (the owners), has a meeting and listens to management's recommendation about how much of the profit should be reinvested in growth, how much should be used to pay down debt, how much should be used to buy back stock, and how much should be mailed to the owners. That last part - the money mailed to the owners - is called a dividend.
The process of making money through dividend investing involves searching for companies that have a good chance of increasing the dividend year after year, causing more money to flow into your bank account. As sales and profits grow, so too does the dividend, or so the thinking goes. The money you make from your dividends can be reinvested, used to pay household bills, send a child to college, start a business, or give to charity. The more shares you own of high quality dividend stocks, the more money you make from dividends. In effect, a dividend investor goes through life collecting a specific type of investment like a child might collect baseball cards. Done correctly, the dividend investor's net worth and household income continues to expand and grow ever richer as time passes. Over 30, 40, 50 years or longer, it would be possible to be earning hundreds of thousands of dollars a year, or more, from dividends.
An Example of Making Money from Dividend Investing
To see how this works in the real world, imagine a young man named Anthony. He is 18 years old and just joining the work force. He decides that he wants to start making money from dividend stocks so he begins investing in shares of high quality, blue chip companies that show healthy growth, strong balance sheets, and which have a history of increasing the dividend paid to stockholders over time. He wants to avoid taxes so he opens a Roth IRA to hold his dividend stocks and he makes sure to take advantage of the Roth IRA contribution limit each year. That means he can save $5,000 annually, or $416.67 per month. As long as he follows the rules of Roth IRA investing, he will never pay a single penny in taxes on the money he makes in the account.
Anthony manages to grow his investments at 8% for 50 years. By the time he reaches his late 60's and is ready to retire, his portfolio has blossomed to $2,868,851. If he insists on an average dividend yield of 5%, he would be collecting $143,442.55 in cash dividends each year. Remember, he doesn't have to pay a single penny in taxes on any of this income because the stocks are held within the Roth IRA.
Important Things to Consider When Trying to Make Money from Dividend Investing
Making money from dividend investing involves a handful of key considerations. These include:
- The dividend yield a stock offers at the time of purchase.
- The rate of growth in the company's profit, which might be used to project future dividend increases.
- The health of the company's balance sheet. Investing in companies with tons of debt and declining sales is still risky no matter how large the dividend may appear.
- The current dividend tax laws.
If you don't want to select individual dividend stocks but you still want to try your hand at making money with dividend investing, you might want to consider a low-cost index fund that specializes in dividend companies. One famous dividend index is the S&P 500 Dividend Aristocrats Index, which tracks large, high quality blue chip stocks in the S&P 500 that have successfully raised their dividend every year for the past 25 years. There are dividend focused exchange traded funds (ETFs) such as the iShares Dow Jones Select Dividend Index or the Vanguard Dividend Appreciation ETF. Be sure to read the mutual fund prospectus for any potential investment to make sure you understand how the stocks held in the fund are chosen and determine whether the risks are right for you and your financial situation.