This article was reviewed by Chris Singer, CFP®.
Stocks and profits and dividends, oh my! The investment market can seem like a complicated and scary world, but investing principles are relatively simple to understand. We often see people make subpar choices with their finances because they don’t understand what they are investing in or the power of compounding—so settle in and get ready to learn some investing tips.
Dividends, in particular, are a powerful tool to grow your money. We’re going to break down how they work, their benefits, and characteristics of companies we choose to invest with to increase our opportunity of collecting regular investment income.
Understanding Stocks
As you may know, stocks are a way to own part of a company. Companies can sell shares to raise money to grow or invest, and those are called stocks. So buying stock makes you a part-owner in a company—albeit a very small part usually.
When you own stock in a company, you can make money when the value of the stock rises. Similarly, you could lose money if the stock market goes down or the company loses value and their shares decrease in value.
Not all stocks are the same from a risk profile. Bigger blue chip companies like Royal Bank or Johnson & Johnson would be seen typically as a medium-risk since they are large in scope—and while they fluctuate—are stable, established companies. On the other end of the scale, you have high-risk companies like startups and small cap. These companies have the opportunity for big returns, but can fluctuate a lot and have a higher rate of failure. These high-risk companies also typically do not have profits and do not pay dividends.
Understanding Dividends
So how do dividends come in? Well, think of it like profit sharing.
We like to explain dividends like owning a rental property. Imagine you own an apartment that generates rental income every month. You own the apartment, but also receive income from rent. This is essentially how dividends work—a company generates income from its operations and may choose to pay out a portion of that income to its shareholders in the form of dividends.
However dividend payments can change depending on the company and its profits. The company’s financial performance, poor management, or decision to invest in research or development may impact dividend payments, making it a potentially unreliable source of income.
Reinvesting Dividends
The real magic of dividends comes in when you don’t collect them as income, but reinvest them and buy more stocks. This creates a compounding effect, and can drastically increase your money, making for much larger dividends in the future. If you’re already retired, dividends can nicely supplement your income payments.
The Importance of Dividends
Income benefits
Dividends can be a safety net during down markets. They offer a regular income stream that can supplement your other sources of income, which is particularly helpful for retirees or anyone else who relies on their investments for income. Dividends also help protect investors against inflation, as they can increase over time and provide a hedge against rising prices.
Companies that pay dividends tend to be established and profitable, providing investors with the potential for capital appreciation in addition to the income they receive from dividends.
Compounding Investments
As we mentioned before, dividend payments offer the potential for compound growth if you don’t need the income for immediate spending. You can reinvest the money you receive from dividends into your existing investments, increasing your payments and creating larger dividends in the future. This compounding effect is a powerful way to grow your money!
Tax Benefits
The tax benefits of Canadian dividends depend on several factors, including the type of dividend and your tax bracket. An investor in a lower tax bracket may not owe any taxes on qualified dividends, while an investor in a higher tax bracket may owe up to 20% on qualified dividends.
Types of Dividend Taxation
Two types of dividend taxation can impact the income you make from your stocks.
Qualified dividends are typically taxed at the same rates as long-term capital gains, which are generally lower than ordinary income tax rates. To be considered qualified, a dividend must meet certain requirements, being paid by a specific corporation and held for a certain period.
On the other hand, ordinary dividends are taxed at the investor’s standard income tax rate, which can be significantly higher than the rate for qualified dividends.
Picking Your Investment Companies
When we choose which companies to buy stock in, we consider a few main points to protect our investments. Large and established companies are the safest because they’re less likely to drop in price or suddenly go out of business. Their stability means we typically receive consistent dividends, which can be a more reliable income source.
Some of the other benefits of large and established companies are less volatility, meaning they’ll be less likely to experience price swings which will help maximize returns long-term. Their proven reputation helps increase the value of their brand and draw in more customers and investors. They also have greater long-term potential, leading to higher growth.
While they may not be as exciting as some new, flashy companies, they’re a safer bet to grow your hard-earned cash.
Let’s look at an example with Johnson & Johnson.
Exploring Your Options
Investing in the stock market and dividends is an excellent way to prepare for retirement and build extra income. We know it’s a complicated and often overwhelming process, so book a call with us any time to explore your options and get some expert advice.
In the meantime, read our eBook to learn how you can plan for your golden years and get some valuable tips on preparing for retirement!
Disclosure:
ACPI is regulated by the Investment Industry Regulatory Organization of Canada (www.iiroc.ca) and a Member of the Canadian Investor Protection Fund (www.cipf.ca). Jay Brecknell is registered to advise in (securities and/or mutual funds) to clients residing in BC.
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Jay Brecknell is a Certified Financial Planner in BC. This material is prepared for general circulation and may not reflect your individual financial circumstances. Jay can be reached at cedarrockfinancial.com.