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Making money from dividends is one of the basic foundations of good investing. Too often, new investors don't fully know what dividends are, how dividends work, and how you can make money by investing in dividend stocks. To help you gain a greater understanding, I wrote an extensive special guide called The Complete Beginner's Guide to Dividends and Dividend Investing. Here, in this article, I want to provide you with a brief overview of the process of making money from these types of investments.
Think of this as a ten-minute course syllabus to making money by investing in dividend paying stocks.
Want to know how to make money with dividends? Essentially, it all boils down to one simple fact: A company earns a profit. The Board of Directors, the members who 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, pay for vacations, or given 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 alone.
To see how this works in the real world, imagine a young man named Anthony. He's 18 years old and has just joined the workforce. 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, making sure to take advantage of the Roth IRA contribution limit each year. That means he can save $5,500 annually, or $458.33 per month. As long as he follows the rules of Roth IRAinvesting, 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 the next 50 years. By the time he reaches 68 years old and is ready to retire, his portfolio has blossomed to $3,155,735.86.
If he insists on an average dividend yield of 3%, he would be collecting $94,672.08 in cash dividends each year. Remember, he doesn't have to pay a single penny in taxes on this income because the stocks are held within the Roth IRA.
Making money from dividend investing involves a handful of key considerations. These include:
If you don't want to select individual dividend stocks but 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 paying 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.
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