Learning how to invest in dividend stocks can be an important lesson for new investors. After all, it’s possible to still receive income from a portfolio without selling shares.

Some companies offer a regular dividend. This is a method of returning excess capital to shareholders. And it’s usually in the form of a cash dividend with a specified amount paid per share.

So, let’s explore how dividend investing works.

Why invest in dividend stocks?

Dividend stocks have a lot to offer an investor. They provide a source of passive income while simultaneously offering the potential for capital appreciation through a rising stock price. And in some countries, income from dividends is even taxable at lower rates than regular income.

But suppose an investor doesn’t need the extra income to cover living expenses? In this case, learning how to invest in dividend shares can still be useful. Why? Because most investment accounts can automatically reinvest any payouts received, often at significantly reduced transaction fees. This not only means acquiring additional shares but also accelerates the wealth-building effects of compounding.

What’s more, income stocks have historically been less volatile than growth stocks. And that can be pretty desirable depending on an investor’s risk tolerance.

How do dividend stocks work?

Generally, investors buy shares in a company with the hope of generating a high return on investment in the future. These returns may be in the form of capital gains, that is, share price appreciation or dividends paid to shareholders from a company’s excess earnings.

When a business generates more cash than it knows what to do with, management teams often return it to shareholders via share buybacks or a dividend. Typically the latter is paid on a regular schedule, either monthly, quarterly (most common), bi-annually or once per year.

When shareholder cash payouts are made, the money is automatically sent to an investor’s brokerage account. When that is not possible, they are often mailed as a cheque instead. And metrics like the dividend payout ratio and yield can provide valuable insight for income-seeking investors.

However, it’s important to remember that companies can still backtrack on their decision even after a shareholder payout is declared. That’s because dividends are entirely optional for a company to offer. Payments can be cut, suspended, or even outright cancelled at the management team’s discretion.

Making such decisions can have a significant adverse impact on a firm’s stock price. However, a business may have little choice if it needs to retain capital to fund internal projects or pay down debts.

How to invest in dividends stocks

Before setting off on an investment journey, it’s paramount for investors to define their investment goals. These can be as simple as building a larger pension pot or saving up for a downpayment on a home. By specifying objectives clearly, investors can filter out investments that are not suitable for achieving their target. They can also help establish their investment time horizon as well as risk tolerance.

Once this initial planning step is complete, investors can get started on their dividend-paying stock-finding extravaganza.

1. Open a brokerage account

A dividend investor must have a brokerage account to access and invest in the stock market. These are sometimes referred to as investment accounts.

There are various types of brokerage accounts to choose from. And each offers different features, advantages and drawbacks. Investors need to consider their personal circumstances and intended investing strategy when deciding the suitable account type.

• Standard Account – This is the most common type of investment account. Investors deposit capital to buy an array of financial products, including stocks, bonds, mutual funds, trusts, and ETFs. In the United Kingdom, all capital gains and dividends received through investments in a standard trading account are subject to tax.
• Employer-Sponsored Retirement Account – This is a special investment account with certain tax benefits. However, withdrawals from this account are restricted until investors reach a certain age. They are designed to be a saving instrument for pensions. The most common type of employer-sponsored retirement account in the United States is a 401(k).
• Stocks and Shares ISA Account – This is a special tax-efficient investment account for British investors only. All capital gains and dividends received from investments within a Stocks and Shares ISA are tax-free. However, investors can only deposit a maximum of £20,000 per year.
• Self-Invested Personal Pension (SIPP) Account – This is a special tax-deferred investment account for British investors only. Capital gains and dividends received from investments are protected from tax. However, investors cannot withdraw any funds until reaching the age of 55 (57 from 2028). When funds are taken out, they are taxed as regular income.

2. Find stocks that pay dividends

With an account open and funded, investors must decide which dividend stock or stocks they want to buy. But that requires finding them first. Not every publically traded stock offers a shareholder dividend. And the ones that do may not necessarily continue in the future.

There are various tools available online for finding and screening income stocks. However, a common shortcut in the dividend investing strategy is exploring the list of dividend aristocrat stocks. These businesses have successfully raised dividends for over 25 consecutive years.

3. Investigate the quality of cash flow

After establishing a list of potential investment opportunities, it’s time to filter out the duds. After all, investing in an income stock that can’t reliably provide income isn’t a sensible idea.

Since dividends are funded by excess capital, investigating the quality of a firm’s cash flow is paramount. Companies undergoing distress may have a high dividend yield but little chance of sustaining it. Similarly, a balance sheet with lots of debt may put new pressure on cash flows in the face of rising interest rates.

Some helpful factors to consider when analysing a dividend stock are outlined later in this article.

4. Buy high-quality shares

With a dividend stock selected and thoroughly analysed, investors can now execute the trades and buy the shares. However, it’s important to remember to keep a portfolio diversified. Becoming overweight in a single source of dividends increases portfolio risk. And the last thing any investor wants is to watch their passive income disappear seemingly overnight.

Key factors to consider when investing in dividend stocks

When investigating an income stock, there are several critical elements that investment analysts often scrutinise.

• Dividend History – Companies that have historically maintained and expanded shareholder dividends are likelier to continue doing so than businesses that haven’t. Firms will declare their dividend history on their investor relations website. However, the information can also be found on useful websites such as DividendData or the London Stock Exchange for UK shares.
• Payout Ratio – The payout ratio enables investors to determine the amount of net income that is eaten by dividends. This can help investors estimate the possible returns on investment before buying any shares. Learn how to calculate the payout ratio.
• Dividend yield – The dividend yield indicates the proportion of dividends paid out as a factor of share price. A dividend yield that is too low can create opportunity costs. But, a yield that’s too high can indicate unsustainability. Learn how to calculate the dividend yield.

How are dividends taxed?

The taxation of dividends differs depending on which country an investor resides in. Here in the UK, dividends are classified as a form of income and are therefore taxable. However, an exception is made for any income from a tax-efficient account such as a Stocks and Shares ISA.

The tax rate charged on dividends varies depending on which tax bracket an individual falls in. It’s also important to note that tax rates are set by the British Government and are subject to change.

An investor can determine which tax bracket they fall into depending on their salary.

• Basic Rate – Earning £1,000 to £36,700 per year.
• Higher Rate – Earning £36,701 to £125,140 per year.
• Additional Rate – Earning more than £125,140 per year.

Additionally, UK investors benefit from an annual dividend tax allowance. In the 2022/2023 tax year, any dividends received under £2,000 are tax-free even outside a Stocks and Shares ISA. However, following changes in the national budget, this tax allowance is dropping to £1,000 in the 2023/2024 tax year and then to £500 in the 2024/2025 tax year.

The bottom line

When executing a dividend investing strategy, focus should not just be placed on the dividend-paying history of the company. A key takeaway from learning how to invest in dividend stocks is to investigate a company’s cash flow and balance sheet. This is because the overall performance of a company is vital to ensuring sustainability in its dividend payment. More so, investors should diversify their portfolios across different stocks to maximise their returns.

This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.