How to Live Off of Dividends
By: Jeff Brown

Fixed-income investors are in a tough spot. Yields on the safest savings, like certificates of deposit, are pitifully low. Reaching for higher yields with long-term holdings like 10-year Treasury notes means risking loss of principal if prevailing rates rise, as many experts expect them to.

So, what about dividend-paying stocks? The stock-screening function at Morningstar (Stock Quote: MORN) can instantly compile a list of 200 stocks with dividend yields exceeding 6%, with many paying in the double digits. And dividends are taxed at a maximum rate of 15%, while interest earnings are taxed as income at rates as high as 35%.

Dividends look especially enticing given that the average five-year certificate of deposit pays just 2.18%, according to the BankingMyWay survey. Money-market accounts average 0.359%, savings accounts 0.216% and interest-bearing checking accounts 0.132%. That means most “safe” savings are losing money with inflation around 1.8%.

Dividend-paying stocks have lots of fans, and can play an important role in a portfolio so long as the investor can handle the risks of fluctuating share prices. Dividend payers are probably not the best place to keep next week’s grocery money, but can make up part of one’s income-producing holdings.

Dividends, of course, are a portion of corporate profits paid to shareholders. Not all profitable companies pay dividends, as many prefer to reinvest in expansion, research and other strategies expected to boost a firm’s share price.

Dividend yield is figured by dividing per-share dividends paid over the past 12 months by the share price. A $100 stock paying $5 a year yields 5%.

But dividend yield is not identical to savings yield because there’s no risk of losing principal with federally insured deposits, while a stock’s price can fall. Often, stocks with the highest dividend yields are bad bets because some trouble has driven the share price down, and a dividend cut may follow. The $100 stock yielding 5% would yield 10% if the share price fell to $50 and dividends stayed the same.

Still, most companies are loath to cut dividends, as it enrages shareholders and highlights problems. Companies generally do not pay dividends, or raise them, unless they feel they’ll be able to keep the payments flowing.

An analysis by John Hancock mutual funds found that dividend-paying stocks did especially well versus non-dividend payers in two of the three most recent stock-market recoveries, and data from Standard & Poor’s (Stock Quote: MHP) show dividends accounted for about 45% of the S&P 500’s total return from 1926 through 2008, with the rest from share-price gains.

But that assumes the dividends were reinvested in more shares of the same stock, not drawn off as income. Over the 20 years ended Dec. 31, 2008, the S&P 500 returned 11.4% a year with dividends reinvested, 8.1% if they were not.

Many income-oriented mutual funds and exchange-traded funds are packed with dividend payers, but these holdings’ diversification tends to dampen dividend earnings. One of Morningstar’s picks, American Century Equity Income Fund (Stock Quote: TWEIX), yields 3.24%, which isn’t shabby compared to bank savings. But is it enough to justify the risk of stocks? The fund’s investors have nothing to complain about, as the fund has returned about 7.4% a year over the past decade, beating the S&P 500 by nearly 8 percentage points. But that makes the fund a good stock bet, not necessarily a good source of dividend income.

Diehard dividend hunters tend to focus on individual stocks, hunting with services like the Morningstar screener, set to find stocks with big yields. Of course, it’s important to look carefully at any stock, to make sure a big yield is a mark of good health, not a tumbling share price.

Among stocks worth examining are the 30 in the Dow Jones Industrial Average. Some well-known companies are paying healthy dividends, with AT&T (Stock Quote: T) and Verizon (Stock Quote: VZ) each yielding about 6%. Dupont (Stock Quote: DD) yields nearly 5% and Kraft Foods (Stock Quote: KFT) about 4%.

—For more ways to save, spend, invest and borrow, visit MainStreet.com.

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