Dividend Paying Stocks

When interest rates are low, retirees and other investors turn to dividend paying stocks to provide them with a reliable source of income.  In fact, investing in companies paying high dividend yields is often viewed as the "sensible" or "rainy day" approach to creating an investment portfolio.

Companies Paying High Dividends

Common stocks paying high dividends are often associated with utilities and financial institutions.  This occurs for several different reasons.  If we use electric utilities as the example, we might conclude that high dividends were the result of limited internal investment opportunities.  Let's take a closer look at this example, because it helps us understand why companies offer dividends to their stockholders in the first place.

If you were the Chief Financial Officer of an electric utility, then you have a choice to make at the end of each earnings period.  You can use profits to pay down debt, or to repurchase shares of common stock, thereby reducing the financial leverage of the company.  You can also use profits to reinvest in the company itself.  This strategy is frequently used by companies with a lot of growth potential.  Finally, you can return earnings to your shareholders in the form of dividends.

In reality, the CFO is constantly evaluating opportunities to use earnings in a way that provides the greatest benefits to its shareholders.  But often the alternatives are limited, especially for large companies in mature industries.

For example, most electric utilities have a franchise territory.  Electric utilities that are in well-developed states may not have a lot of opportunity to grow their business.  They are limited by the geographic size of their franchise territory.  In this example, the CFO may decide to return a larger proportion of earnings to shareholders in the form of dividends.

Dividend Paying Stocks of the Dow

Now that we have a better understanding of why a company might offer shareholders a high dividend yield, let's take a closer look at the yields of some blue chip stocks.  We used a stock screener to pull a list of stocks that are members of the Dow Jones Industrials that are paying dividends in excess of 3.25% (February 2011).

If we look at the smaller set of the Dow Jones Utilities, those stocks paying dividends in excess of 3.25% include:

If we analyze the above information, we can see that seven of the thirty stocks (23.3%) in the Dow Jones industrials were paying dividends of 3.25% or higher.  Of the 15 stocks in the Utility Index, thirteen of these (86.7%) were paying dividends in excess of 3.25%.  The theory behind utilities paying high dividends holds true in the data.

Dividends and Taxes

Changes to tax code make the payment of dividends to investors even more attractive.  That's because qualified dividends are taxed at a lower rate than ordinary dividends as explained below.  This has resulted in even higher dividend payouts from stocks of those companies already providing investors with good yields.

Ordinary Stock Dividends

Ordinary dividends are paid out of the earnings and profits of a company.   They are federally taxable as ordinary income unless they meet the standard test for qualified dividends.  Said another way, ordinary dividends are those that do not meet the standards or requirements to be considered qualified dividends.

Qualified Dividends

Qualified stock dividends are ordinary dividends received in tax years after 2002 that are subject to the same federal income tax rate as net capital gains (5% or 15% maximum tax rate).  If your applicable "regular" tax rate is 25% or higher, then the qualified dividends are taxed at the new 15% capital gains maximum.  If your "regular tax" rate is less than 25%, then qualified dividends are taxed at the new 5% capital gains rate.

Capital Gains Eligibility Rules

For stock dividends to be eligible for the new capital gains rates, those dividends must meet all of the following requirements:

• Dividends must be paid by a U.S. corporation or a qualified foreign corporation.
• Dividends cannot be those that are specifically excluded from qualified dividends (includes capital gains, dividends from savings bank accounts, dividends on ESOPs).
• Stock holding periods must be met.  For common stock, the holding period is more than 60 days of a 121-day timeline (60 days before the stock goes ex-dividend and 60 days after the ex-dividend date).  Preferred stock must be held for more than 90 days of a 181-day timeline (90 days before the stock goes ex-dividend and 90 days after the stock goes ex-dividend).

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