Dividend-paying stocks: Pros and cons

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Investing in companies that have historically paid regular dividends could help provide income and diversify your portfolio, though there are risks you should keep in mind.

A dividend is a portion of a company’s profit that’s paid to shareholders. That means dividend-paying stocks may provide a source of income. But they can also carry some degree of risk.

So, what do investors need to consider when it comes to dividend-paying stocks? In this Q&A, Ken Johnson, CFA, equity strategy analyst with Wells Fargo Investment Institute, provides important information for investors to keep in mind.

1. What are the potential benefits of dividend-paying stocks?

“One of the big benefits is that these stocks may provide a more reliable income stream compared to some other investment options,” Johnson says.

Companies tend to issue dividends on a routine basis, such as quarterly or semi-annually, which may create a dependable income stream. Another benefit? The stocks can yield some favorable tax treatment.

“It’s going to depend on your tax situation,” Johnson says, “but in general, you may have a relatively lower tax rate for dividends compared to income gained by selling investments.” As long as the dividend -paying stock meets IRS requirements for a qualified dividend, the dividend is taxed at the lower long-term capital gains tax rate instead of being taxed as regular capital gains income. “So an investor could receive income from a dividend-paying stock without selling the stock, and have a lower tax bill compared to that of a non-dividend-paying stock, which must be sold to receive income,” he says.

It’s going to depend on your tax situation, but in general, you may have a relatively lower tax rate for dividends compared to income gained by selling investments.

2. Who should include dividend-paying stocks in their portfolio?

Many types of investors have the potential to benefit from dividend-paying stocks. “But these stocks may be more valuable for investors who are a bit older — maybe those in retirement or close to retirement who really value a more reliable income stream,” Johnson says. “I think they’re typically beneficial from a diversification perspective, especially when interest rates are low. Dividend-paying stocks tend to have an inverse relationship with interest rates: When interest rates go down, you may see some of these dividend-paying stocks perform better.”

3. What are the risks associated with dividend-paying stocks?

“Firms can reduce or cancel their dividends — especially during times of economic uncertainty and times of crisis such as COVID-19,” says Johnson. “And there’s still the risk that dividends could be cut periodically, even without the trigger of a crisis event. And if tax rates change, it could mean you’d pay more, as well.”

Explore your options with professional advisors

Johnson stresses that investors should discuss the pros and cons of dividend-paying stocks with a financial advisor to help make sure they fill a need within an individual investment portfolio and make sense for a specific financial situation.

“You should also talk to your CPA or tax professional to make sure that you understand what the tax consequences are for your particular situation,” he advises.

Equity securities are subject to market risk, which means their value may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Investments in equity securities are generally more volatile than other types of securities. There is no guarantee that dividend-paying stocks will return more than the overall stock market. Dividends are not guaranteed and are subject to change or elimination.

Wells Fargo & Company and its affiliates do not provide legal or tax advice.