Five reasons why dividends are an investor’s best friend

Why are dividends so important? After all, it’s not as if investors earn anything from the dividend, because the stock price adjusts less (all else being equal) on the ex-dividend date. I realize the dividend tax credit is a major advantage, but are there any other advantages?

This is a great question. First, I’ll detail the dividend tax credit. Then I will discuss some of the many other benefits of investing in dividend stocks.

Dividends give you ‘credit’

The reader is right that yield, by itself, does not create any value. Dividends are paid out of the company’s after-tax earnings, so the dollar for each share an investor acquires is one dollar for each less share in the company’s coffers. That is why, in theory at least, on the ex-dividend date, the stock price should fall by the amount of the dividend. It’s rarely done in exactly this way, because many other factors influence the company’s stock price.

But the way dividends are taxed benefits investors. A distributed tax credit, in effect, gives investors “credit” for tax already paid at the company level. As a result, the personal marginal tax rates for dividends are much lower than the tax rates for interest and other income.

In Ontario, for example, an individual earning $100,000 in taxable income for 2022 would pay a combined provincial and federal marginal tax of 17.79 percent on qualified stock dividends, compared to 37.91 percent for ordinary income. (Dividends are also taxed at a lower rate than capital gains, although the opposite is true for incomes over $100,392 in Ontario. Visit TaxTips.ca to see each province’s marginal tax rates.)

At lower income levels, profits have a greater advantage. Someone with $60,000 of taxable income in Ontario would pay a tax of just 6.39 percent on dividends, as opposed to 29.65 percent on interest or other income. At taxable income of $50,197 or less, the marginal tax rate on dividends is actually negative. Since the dividend tax credit is a non-refundable credit, the government will not send you a check for the negative amount. But you can use it to offset other taxes you owe.

Dividends reward good behavior

One of the worst things an investor can do is trade frequently. Not only does it increase commission costs and taxes, but it can lead to mistakes such as chasing overvalued shares or selling perfectly good companies when their shares hit a rough patch. Selling to “make a profit” is another common mistake. Often times, simply buying a great company and keeping it through the good and bad times is a more profitable — and less stressful — strategy.

Dividends are a great way to develop a buy-and-hold system. If you know you’ll receive a dividend in the next quarter—and that the company has a track record of increasing its payouts—you’ll be more inclined to keep investing to keep the money flowing in your pocket. Dividends also help investors weather market turmoil. Even as stock prices bounce up and down, dividends for many companies — such as banks, utilities, and consumer companies — remain very stable.

Dividends can keep you out of trouble

It’s normal to feel envy when your friends kill stocks like Shopify Inc. (SHOP) and Netlix Inc. (NFLX). But when was the last time you saw a facility or pipeline lose more than 70 percent of its value within five months? This is what happened to each of these previously soaring stocks after the market decided the tech party was over.

It is true that dividend stocks can incur losses as well. But the odds of a similar crushing decline for a facility like Fortis Inc. (FTS) or a pipeline such as TC Energy Corp. (TRP) far. This is because their earnings are more predictable and their valuations are generally more reasonable, rather than being based on optimistic growth assumptions. Companies with stable and growing profits are also strong companies at the conservative end of the risk spectrum.

Moreover, a stable, well-covered dividend can help limit the downside for some stocks because the yield – which rises as the share price falls – may attract more buyers.

Increased profits help you fight inflation

I don’t need to remind you that prices for everything from petrol to groceries are off limits. With Canada’s inflation rate hitting a 31-year high of 6.7 per cent in March, people are watching their purchasing power eat up alive. But the damage is not as bad for investors who own stocks with an increased dividend. To take one example from my hog yield growth portfolio model, Brookfield Infrastructure Partners LP (BIP.UN) in February raised its dividend by 6 percent, continuing the pattern of annual increases. The vast majority of other stocks in the model portfolio have also raised their dividends at least once in the past year. (Note: BIP.UN payments are not exclusive dividends; to get the full benefit of the dividend tax credit, you’ll need to invest in our sister company, Brookfield Infrastructure Corp, ticker symbol BIPC.)

Dividends are part of a balanced investment diet

Diversity is the spice of life, and this also applies to investing. In my personal portfolio, I also own broad Canadian and US index ETFs to trade in other sectors such as technology, energy, and materials that don’t usually pay big (or stable) dividends. Diversification helps reduce the fear of getting lost when these sectors are up, and it also limits the damage when previously hot sectors cool off, as we saw recently with technology.

By owning dividend stocks, you can keep your taxes low, control your desire to trade and keep your emotions in check during turbulent times. Best of all, due to the increasing influx of cash dividend flow into your brokerage account, you can experience the thrill of getting paid for doing absolutely nothing.

Full disclosure: The author personally owns shares of FTS, TRP, BIP.UN and BIPC.

Email your questions to jheinzl@globeandmail.com. I can’t personally reply to emails but I chose some questions to answer in my column.

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