Dividend Dilemma: Is It Worth it to Get in the Game?

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Investors who want steady income are having a hard time of it these days, as yields on bank savings, money markets and government bonds are pitifully low. You’re lucky to get 2%, and would have to tie your money up a pretty long time to do any better.

So why not look to dividend-paying stocks?

Consider the top three dividend payers in the Dow Jones Industrial Average. AT&T (Stock Quote: T) pays 6.41%, Verizon Communications (Stock Quote: VZ) pays 6.25% and Dupont (Stock Quote: DD) 4.4%. (These are all estimates for the 12 months beginning Sept. 17, by investment-data firm IndexArb.)

Dividends are corporate earnings paid out to shareholders. Dividend yield is total dividends paid over 12 months divided by a stock’s current price. A $100 stock paying $6 in dividends over a year yields 6%. This means that dividend yield is comparable to interest rate. So the 4.72% paid by Merck (Stock Quote: MRK) is a lot better than the 1.52%, which is what you’d earn on the average two-year CD, according to the BankingMyWay.com survey.

Also, the federal tax on dividends is 15%, while interest earnings are taxed as income at rates as high as 35%.

It all sounds great, and lots of investors, including many retirees, swear by dividends. But there are things to watch out for.

The most obvious is the risk that a stock which pays a generous dividend could fall in price, creating a loss despite the dividend earnings. The search for generous dividends should therefore include all the analysis you’d do before any stock purchase.

Very high dividend yields, such as any in the double digits or high single digits, are a red flag. They often result from a falling stock price, which suggests the company is in trouble. The stock could fall further, and the company could reduce the dividend. Standard & Poor’s says 250 companies cut dividend payouts in the second quarter, the highest number in more than 50 years.

Diversifying your holdings of dividend-paying stocks can help reduce risks, and the easiest way to diversify is to buy mutual funds that emphasize generous dividend payers.

Morningstar Inc. (Stock Quote: MORN), the fund- and stock-data company, does not have a specific category for funds emphasizing dividends, but many such funds are found in the “large value” category. Those funds contain stocks of big companies, which are more likely to pay dividends than small companies.

Vanguard’s Equity Income Fund (Stock Quote: VEIPX) yields 3.88%, according to Morningstar. But like any stock fund it has a lot more risk than bank savings, having lost 31% in 2008. Use the Morningstar Similar Funds finder to locate other dividend-emphasizing funds. Many have the term “equity income” in their names.

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