By Brad Lafferty
Dividends accounted for almost all of the S&P 500 returns from the beginning of 2000 to the end of September 2012.
Dividend (div΄ uh dend) n. A sum of money paid regularly by a company to its shareholders out of its profits or reserves.
Savvy investors have long understood the power of dividends. Think about it, if I receive a percentage of the value of my investment on a regular basis, every time I get paid, I lower my overall risk to my principal. Also, I may see a larger overall return on an investment that rises in value if I am realizing a regular dividend from that company. Seems simple enough, but don’t rush in too quick. When choosing dividend paying investments, always ask the following questions:
- What is the source of dividends? Investments may legally pay a dividend from a number of sources including profits, cash, incurred debt, investor money, or any other source. Read your shareholder reports and prospectuses. A high dividend may or may not mean a profitable company or investment. Understand the source of the dividends before getting too excited about the yield.
- What is the FFO? FFO, or Funds from Operations, is a key metric for gauging the health of many investments; especially non-traded real estate investment trusts (REITs) and business development companies (BDCs). The measurement determines the percentage of the dividend that is derived from the operating revenue of the company. If the FFO coverage is only 90%, that means that 10% of the dividend may be coming from cash, debt or other sources, rather than from profits. If this does not improve, it may hurt the success of the investment over time.
- How are dividend payouts determined? Dividends are paid at the discretion of the company or fund. They are not guaranteed and may be changed or stopped at the discretion of the company or fund. It is wise to research the history and track record of the investment and its management when choosing a dividend paying security, especially if income is one of the goals for choosing the investment.
- Are dividends taxable? If you receive dividends in a non-qualified account, they are generally considered taxable income and should be reported to avoid problems with the IRS or your state taxing authority. You should expect a 1099-DIV for these dividends.
- Is All Investment Income a Dividend? If you have a Limited Partnership, for example, you may receive a periodic payment each month or quarter, but the payment is not a dividend, per se. You may also notice on your statement that there is a return of principal included as a portion of some or all of your income payments. These are partnership distributions, not dividends, and will have different tax consequences than ordinary dividends. Partnership distributions that include a return of your capital are often paid out to defer taxation of the profits and increase possibility of a long term capital gain. Be certain to verify whether a limited partnership investment creates UBTI (Unrelated Business Tax Income) before purchasing into an IRA. UBTI can create a tax inside an IRA, even though the IRA provides tax deferral for earnings. A possible indicator of potential UBTI tax is whether the tax reporting is a K-1 rather than a 1099-DIV.