How to Live Off of Dividends

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.

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