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Dividend Income Investing – Constructing a Dividend Income Stock Portfolio

Source: sxc.hu Photo: penywise
Source: sxc.hu Photo: penywise

Investing for dividend income is a smart way to invest in the market and participate in the profits of successful businesses. Sure, the income from dividends might not be as tax efficient as long term capital gains, but there are many other benefits. Depending on your goals and your situation in life, a well constructed dividend income portfolio maybe something to consider.

Is Dividend Investing the Same as Income Investing?

Great question. Sure, dividends are income so all dividend investing is income investing. But income investing can be done in a variety of ways, stock dividends are only one of them. The interest or coupon payments on bonds is also one way of income investing, and so is private loans to individuals or businesses, either negotiated as a commercial note or done through online debt exchanges such as Prosper or Lending Club. Income from rental property also classifies as income investing. When you compare interest income vs. dividend income or even rental property income, keep in mind that their tax treatments can be quite different. Interest income typically earns the regular income tax rates, while dividend income may be taxed at a lower rate. The income tax laws regarding dividend income keep changing, but the tax rates are generally the same or lower than regular interest income.

You Should Consider a Dividend Portfolio if any of the Following is True

  • You are retired or are close to retirement and need a regular, fairly dependable income stream to live on without having to sell your investments
  • You have a full time job or a business and want to invest in unrelated businesses (diversify your income) and generate additional passive income through dividends
  • You are investing for the long term and are looking for an easy way to find profitable companies to invest in. Dividend paying companies are typically better managed, and the cash flow is less likely to be misrepresented as real cash needs to be paid out to the shareholders as dividends
  • You are looking to invest in DRIPs (Dividend Reinvestment Plans) either for yourself or may be to teach a child about investing using DRIPs. DRIPs allow you to bypass a traditional stock broker and their fees for the most part and invest directly with the company, and you get a real stock certificate in your name.
  • You want the peace of mind that can only come when the stock you invest in shows you the real cash.

Frankly, I like dividend stocks just because they throw up cash that I can than use to make new investments. This allows me to stay fully invested in my stocks so I do not miss those precious few days of stock appreciation in any year that make all the difference between a great performance and a dismal one. Whatever your reasons may be, there are many choices available to you as you select stocks that you want to include in your dividend income portfolio.

Your Investing Choices

Depending on your income requirements, the amount of risk you want to take, as well as the level of complexity you want to handle in your taxes, you may want to integrate one or more of the following types of investments in your portfolio.

  1. Stable no or little growth dividend payers: Most utility companies fall in this category. While these companies do not expect to grow much or grow their dividends much in the future, these companies have a stable customer base, predictable revenue streams and typically some sort of regulatory protection that keeps competition away. You will be rewarded with a predictable quarterly dividend stream and you can sleep better at night knowing it is unlikely that these companies will disappear overnight (Enron and Calpine were exceptions, they went way beyond what a typical staid utility companies do). They also generally pay higher dividends. 4%-6% dividend yield is not uncommon. Two examples are DTE Energy and Southern Company. Beats putting money in a CD any day.
  2. Dividend growth companies: These companies have a long history of not only paying uninterrupted dividends, but they also grow their dividends every year as their business grows. Johnson and Johnson is my favorite, but of course there are many others. It is not uncommon with these companies to find after decades of ownership that the dividends you are getting now every quarter per share are actually more than the original investment in each share of these companies. In other words, you get paid back and more. If you reinvest these dividends in more shares, you actually compound your dividend income even faster. Pretty powerful!
  3. REITs: Real Estate Investment Trusts, or REITs, technically do not pay dividends. The trust payments are classified more as a traditional income. Still these are structured and more liquid way of enjoying real estate/rental income without the hassle of property management, mortgage negotiations, etc. REIT income yield can be high, but depending on what the REIT invests in, you may be on a riskier territory. If you want to go this route, make sure you understand what the REIT is investing in. For example, a REIT that invests in hospitals and medical offices maybe safer than a REIT that invests in developing Florida marshlands for baby boomer retirees.
  4. Royalty Trusts and Master Limited Partnerships: These are less understood but can be highly lucrative. Royalty trusts and MLPs also in the strict sense of the word do not pay dividends. Due to their corporate structure, they pay out a distribution to their unit holders. This distribution is directly linked to the profits in the business they are involved in, as profits technically flow through to the unit holder. As a unit holder, you are considered as a partner in the business, which means that you will receive a partnership K1 form for completing your taxes, which might get quite involved. You will definitely want to get a competent CPA for your taxes. Understand that many CPAs are also not properly educated on how these entities work. The yields can be very high and as a flow through entity, accounting expenses such as depreciation or resource depletion can be used to offset your income tax liability. The risk with US based Royalty trusts are that they will eventually dissolve. They are not allowed to raise new capital or fund growth so as the wells or mines are depleted, so is the income. An alternative is to invest in Canadian trusts (also called CanRoys) that have no such restrictions.

Most of the companies pay dividends on a quarterly basis. There are a few companies that pay annual or semi-annual dividends. REITs, MLPs and Royalty Trusts are your best bets if you are looking for monthly dividend income. Alternatively, you can structure a portfolio of quarterly dividend paying stocks whose dividend schedule fall on successive months. This way you are sure that you will be earning predictable income every month.

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3 Responses to Dividend Income Investing – Constructing a Dividend Income Stock Portfolio

  1. I read this hoping to acquire an actual working portfolio. The explanations are good & valid but I am still reluctant to use MLP’s as I’m not informed enough tax wise. I mentioned them to my CPA at tax time but he really kind of danced around the question, so I have no assurance he has any expertise in that realm. ADVICE PLEASE.

    • Joseph, we will have more information with detailed advice in the coming weeks, so stay tuned. MLPs are indeed a topic that most CPAs do not want to touch as it introduces a bit of complexity and adds time to the tax preparation. Many MLPs recognize this and offer a non-MLP version (essentially stock) which they basically construct using a holding company that owns a stake in underlying MLP. This may be a way to go but it takes away some of the tax benefits on investing in a MLP.

      MLPs also have an annoying habit of mailing out the K1 partnership statements later than Jan 31 (they are not bound by Jan 31 deadline, as far as I know), basically forcing you to go to your CPA when they are most busy. Another reasons CPAs hate MLPs :-)

      But if you look at it from another perspective, MLPs are just partnerships, so if your CPA also works with small businesses, law firms, etc, they should not have too much trouble.

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