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While 2022 has been a rough year for the stock market, stocks remain an important way to invest your money for the long term. But not all stocks are created equal.
From 1965 through 2021, stocks in the S&P 500 index—a widely followed gauge of how the stock market is doing—gained an average of 10.5% a year, as calculated by billionaire Warren Buffett’s Berkshire Hathaway. In those 56 years, S&P 500 stocks as a whole lost value in just 11 years and gained in 45.
Looking at it another way: If back in 1970, a person had started putting $1,000 a year into a stock index fund tied to the S&P 500 and increased their annual investment by 3% each year to cover inflation, their account would be worth nearly $1.9 million by the end of 2017, according to a MarketWatch report. That person would have contributed only about $104,000 of their own money over that 47-year period; the rest would be investment earnings.
Yes, some stocks are money-losing turkeys, and some years are bad for the overall market. There’s always a level of risk to buying stocks, especially for older investors who will need to cash out for retirement soon. But over time and with patience, a diverse stock portfolio can be an excellent investment.
In choosing stocks, you should know that some companies pay dividends to investors who own their shares, and other companies don’t. And there are pros and cons either way. Here’s a guide.
What is a Dividend?
A dividend is a payment made by a company to those who own shares in the company. It’s a bonus to those who invest in a company, and it represents a portion of the company’s profits. Dividends usually are paid in cash or sometimes as additional stock shares.
A company’s board of directors decides whether to pay dividends to shareholders and how much to pay, often based on the size of a company’s earnings. The payout is usually a certain dollar amount per share, so the more stock in a company you own, the bigger your dividend. Dividends are usually announced—or “declared”—quarterly (every three months), but sometimes once a year.
A company facing a loss or other financial difficulties might pass on declaring a dividend in a given quarter, so sometimes that can be a warning sign that a company is not doing well.
Dividends as Income
Certain companies—especially old, big companies in traditional industries—are known for regularly paying dividends. For that reason, some investors are drawn to these companies and buy their stock so they can receive regular dividends as income without having to sell their shares to receive money. In many cases, “income investors” care less about a company’s share price growing and more about predictable dividend payouts.
The S&P 500 Dividend Aristocrats index tracks companies that have increased dividends for each of the last 25 years. As of May 2022, the index included such business giants as Exxon Mobil, Chevron, Sherwin-Williams, and the utility Consolidated Edison.
If dividend stocks appeal to you, keep in mind that dividends are not guaranteed. A company might suspend or reduce its dividend if it hits a rough patch.
Are Dividends Subject to Income Tax?
Generally, you’ll owe tax on dividends you receive. Some dividends are treated as “ordinary” and are taxed at your usual income tax rate. Other dividends are considered “qualified” and taxed at a lower long-term capital gains rate based on several factors. At the end of the year, you should receive a tax form (IRS Form 1099-DIV) from the companies that paid you a dividend, stating whether your dividend payouts are ordinary or qualified.
Other Ways to Earn Dividends
You don’t have to own individual shares to reap dividends. Mutual funds—clusters of stocks—that specialize in high-dividend stocks are available. Usually, you can receive a dividend payout for the stocks held in your mutual fund or elect to have dividends reinvested in the fund.
If you hold mutual funds as part of a tax-deferred 401(k) or IRA retirement plan, generally any tax you would owe on dividends will also be deferred until you withdraw funds at retirement, but double-check with your plan provider to be sure.
Do All Companies Pay Dividends?
‘No. In addition to businesses facing trouble, a number of thriving companies make it a policy not to pay dividends. Instead, they plow all their earnings back into the business to pay for expansion, new products, reducing debt, and other needs. Some are young companies not yet making a profit (which is true of many tech firms), which use their earnings to finance rapid growth. Such stocks often appeal to “growth investors” looking to acquire stocks and sell them later for a much higher price (they hope).
Amazon.com is a prime example of a huge, healthy company with a record of not paying dividends. Instead, it invests in growing its business, buying Whole Foods Market for $13.7 billion in 2017 and the MGM movie studio for $8.5 billion in 2021. So, Amazon investors don’t get dividends, but over the last 10 years, they have enjoyed share-price growth averaging over 30% a year—more than twice the growth rate of the S&P 500 stocks as a whole over that period.
Other big companies known for not paying dividends are:
- Alphabet (the parent company of Google).
- Meta Platforms (parent of Facebook and Instagram).
- AutoNation.
When investors sell stocks they’ve owned for more than a year, their profits—what they receive over what they paid for the stock—are generally taxable at a long-term-capital gains rate lower than the income tax rate. It’s worth checking with a qualified tax advisor on your situation.