Investors turn to high-yield dividend stocks for the income they need from their portfolios. The higher a stock's yield is, the more income it produces compared to the amount you invest, and maximizing income is something many people are desperate to do.
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To be prudent in your investing, though, you have to be more thoughtful about high-yield dividend stocks and the role they should play among your investments. Stocks that boast high yields often share some characteristics that aren't attractive, and if you're not ready to look closely at these companies to judge whether they can sustain the yields they have currently, you can get thrown for a loop later on. Below, we'll look at five things you really need to know about dividend stocks with high yields.
1. Just because a company paid a dividend in the past doesn't mean it has to in the future
The first thing that any dividend investor needs to understand is that companies have no obligation to pay any dividends at all. No matter what they've paid out as dividends in the past, a company always has the right to change its mind and reduce or eliminate its dividend going forward.
Of course, any company wants to build confidence among its shareholders, and being predictable in its dividend payments is a good sign of stability and success for a business. However, if financial conditions change and a company suddenly can't afford to pay out as much cash to its shareholders, the dividend is often the first thing to go.
2. Some companies have to pay out almost all of their income as dividends
Most companies have a choice about how much they pay in dividends. But for certain types of companies, paying out a certain minimum amount of their income is necessary in order to qualify for tax breaks.
For instance, real estate investment trusts have a favorable tax status that allows them to avoid taxation at the corporate level, leaving the only taxes on investors when they receive dividends. In order to get that tax status, REITs have to agree to pay out at least 90% of their taxable income annually. That's good news for investors looking to maximize income, but it leaves the REIT without much of a margin of safety in its payout ratio if earnings fall in the future. Business development companies also have similar rules that explain the high yields they often have.
3. Some investments are designed to pay dividends that will decline or disappear over time
Many dividend investors don't realize that some business entities are set up specifically to own assets that will decline in value over time. The best example is the royalty trust, which typically owns rights related to oil and gas or other natural resource production. Royalty trusts usually have fixed terms over which the business can operate, with rules governing what happens when the trust terminates. With oil and gas wells, production almost always decreases over time, and by the time the trust terminates, the asset might no longer pay any income at all.
The high yields that some royalty trusts pay end up compensating investors for the fact that their initial investment could be worthless by the termination date. Investors in royalty trusts have to be very careful to know the exact terms of the trust to find out whether it's likely to have any residual value at trust termination.
4. Some high-yield dividend stocks get taxed at higher rates than others
Many investors like dividend stocks because they often qualify for a lower tax rate than regular income. However, especially at the high-yield end of the spectrum, some dividend stocks don't get that preferential rate. REITs, BDCs, and similar entities typically have to pass through the tax characteristics of the income they generate, and most of that income usually comes from investments that don't qualify for the lower dividend tax rate. In some cases, the difference in taxation can mean that a higher-yielding stock can give you a lower after-tax effective yield than a lower-yielding stock.
5. Over time, a lower-yield stock can end up paying you more
The final thing high-yield dividend investors need to consider is whether they need to see their income levels increase over time. Often, high-yield stocks don't have much capacity to grow their dividends further, while those that pay lower dividends still have growing businesses that can boost earnings over time and lead to higher dividend payments in the future. A stock yielding 6% right now will pay more current income than another yielding 4%, but if the 4%-yielding stock grows its dividends at 20% per year while the 6%-yielding stock keeps its payouts flat, the rising payout will catch up with the higher current yield within just a few years.
Be smart about dividends
Dividend stocks are an important source of portfolio income, but you can't afford to be greedy. Knowing the risks and trade-offs of owning high-yield dividend stocks shows the importance of a balanced portfolio that goes beyond simply trying to maximize current income.
This article originally appeared on The Motley Fool.