5 First Steps To Take To Earn Passive Income Through Dividend Stocks
Written by
John Csiszar
Edited by
Amen Oyiboke
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Dividend stock investing can be a great way to generate current income while maintaining the potential for capital gains. However, you’ll have to do your research to pick which is the best type of dividend stock for you, and you’ll have to be careful to avoid those that might not be what they seem.
For example, some stocks that pay a very high dividend might actually be financially unstable, leading to a cut or even the elimination of that dividend in short order.
Others may provide more reliable payouts but at a rate that’s too low to meet your income needs. Because of all of these variables, it makes sense to create a plan as to how you could best earn passive income through dividend stocks. Here are the steps you should take.
Understand Dividend Payout Ratios
A dividend payout ratio is the percentage of a company’s earnings that it pays out in the form of a dividend. A high dividend payout ratio means that a company may have trouble coming up with the cash to continue that dividend in the future.
All things being equal, if you’re deciding between two stocks that pay 2.5% dividends, the one with the lower payout ratio will be more likely to not only sustain that dividend but potentially increase it in the future.
Evaluate the Strength and Consistency of a Company’s Dividend
If you’re going to buy a stock for ongoing income, make sure that the company has a solid history of paying dividends, ideally with consistent increases over time.
The “best of the best” when it comes to dividend stocks are the so-called “dividend aristocrats.” These companies have not only paid a dividend for at least 25 years straight, but they have raised their dividend every one of those years as well.
Companies like these tend to have well-defined revenue streams with ample coverage of their dividends, making them good candidates for long-term passive income.
Draft an Income Plan Outlining How Much You’d Like To Earn
Imagine that you have $100,000 in your portfolio, and you’re looking to earn $4,000 in annual income. This means you’ll need to earn a yield of 4%. If you want $6,000 instead, you’ll need a yield of 6%.
Once you define your income needs, you can start screening dividend stocks based on their yield. For example, if you find four stocks you’re interested in that pay 7%, 3%, 4% and 2%, your blended yield will be 4% if you invest your money equally among them.
Of course, your investment choices should take into account other important factors on top of yield, such as historical performance, dividend payout ratio, earnings trends, growth prospects and so on.
Determine Your Preferred Balance Between Income and Growth
Generally speaking, a company with a higher potential for growth will pay a lower dividend. Higher-paying dividend stocks, on the other hand, tend to have more limited opportunities for capital appreciation.
Some investors are looking to maximize their income only, investing in companies like utilities, while others seek a combination of growth and income, trading off some of the highest income opportunities for the chance at capital appreciation.
Before you invest, ensure that any stocks you’re considering match your investment objectives and risk tolerance.
Don’t Forget About Taxation
When determining your net yield from your dividend portfolio, don’t forget to incorporate taxation. As long as you hold your dividend stocks for at least 61 days, the dividends you receive are generally considered “qualified.”
This means that they’re taxed at a special rate of either 20%, 15%, or 0%, depending on your taxable income and filing status. But if you hold your stocks for a shorter period, their dividends become fully taxable at federal rates of up to 37%. These varying tax rates can affect the net amount of income you actually receive each year from your portfolio.
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