How to Build a Dividend Portfolio

Dividends are money. Literally, by definition, dividends are the earnings paid out to shareholders by a company. This is why investors seeking income often turn to dividends over bonds and bank deposit accounts. Dividends provide cash flow while also allowing investors to participate in the appreciation of the asset. Plus, dividends provide favorable tax treatment if you’ve held the securities long enough. If you’re interested in dividend investing but don’t know where to start, we’ll explain what dividends are, why you want them, and how to build a dividend portfolio.

A financial advisor can help you develop your own dividend focused portfolio that aligns with your long-term goals.

What Are Dividends?

Dividends are payments that companies make to shareholders, usually from profits or accumulated earnings. They are often paid in cash on a quarterly basis, although some companies pay monthly, semiannually or annually, and others may issue additional shares instead of cash.

Dividend-paying stocks are commonly associated with established companies that generate steady cash flow and choose to return part of their profits to investors. The amount paid is typically expressed as a dividend per share, while the dividend yield shows the annual dividend as a percentage of the stock’s current price.

For example, if a stock pays $2 in annual dividends and trades at $50 per share, its dividend yield is 4%. That yield can change as the stock price moves, even if the dividend payment stays the same. A high yield may look attractive, but it can also signal that a company’s share price has fallen or that the dividend could be difficult to maintain.

Dividends can provide a regular stream of investment income and may also be reinvested to buy additional shares. Reinvesting dividends can help compound returns over time, especially for long-term investors who continue adding to their portfolios.

However, dividends are not guaranteed. A company can reduce, suspend or eliminate its dividend if its financial condition weakens or management decides to use cash for other priorities. For that reason, investors building a dividend portfolio often look beyond yield alone and consider factors such as earnings, cash flow, payout ratios and a company’s history of maintaining or increasing its dividend.

Qualified vs. Non-qualified Dividends

Qualified and non-qualified dividends can receive different federal tax treatment. Qualified dividends are generally taxed at the lower long-term capital gains rates, while non-qualified dividends, also called ordinary dividends, are typically taxed at the investor’s ordinary income tax rate.

To qualify for the preferential rate, a dividend generally must be paid by a U.S. corporation or certain qualifying foreign corporations, and the investor must meet specific holding-period requirements. For most common stock, that generally means holding the shares for more than 60 days during the 121-day period that begins 60 days before the stock’s ex-dividend date.

Non-qualified dividends do not meet those requirements and are generally taxed as ordinary income. Certain distributions, including some payments from real estate investment trusts (REITs), money market funds and other investments, may also receive different tax treatment depending on their source and classification.

The distinction can make a meaningful difference in a dividend portfolio, especially for investors in higher tax brackets or those holding income-producing assets in taxable accounts. Tax-advantaged accounts such as IRAs and 401(k)s can reduce the immediate importance of dividend classification because taxes are generally deferred or, in the case of qualified Roth withdrawals, potentially avoided altogether.

How Is Dividend Yield Calculated?

When analyzing potential dividend-paying assets, it helps to calculate the dividend yield of the investment. The dividend yield allows you to compare dividend-paying assets against each other, as well as to other investment alternatives (e.g.: bonds, CDs, high-yield savings accounts, REITs).

To calculate an investment’s dividend yield, take the annual dividends paid divided by the current stock price. For example, an investment that pays $5 in dividends with a stock price of $100 has a dividend yield of 5%. Because prices change every day, an investment’s dividend yield fluctuates throughout the year.

Is a High Dividend Yield the Best Choice?

Because of a dividend’s appeal, some investors may seek out investments with the highest dividend yields possible. While this may sound like a good strategy on the surface, it can lead to problems in some situations.

Dividend yields rise when companies increase dividends, but they also rise when a stock’s price falls. If the price falls too much, its dividend yield can spike. When this happens, dividends may be cut or suspended to bring them back to historical percentage levels. Additionally, the investment may be at risk of bankruptcy or closing down for good.

How to Build a Dividend Portfolio for the Futures

Investors reviewing the dividend yield of investments.

To create your dividend portfolio for now and the future, it helps to incorporate the following features into your investment strategy.

Taxable vs. Retirement Account

When you invest in dividend investments within a retirement account, you do not have to worry about the tax status of the dividends. However, when investing through a taxable brokerage account, try to time your purchases so that your dividends are qualified. Qualified dividends are taxed at the same rates as long-term capital gains.

Individual Stocks vs. Mutual Funds/ETFs

You can invest your dividend portfolio in stocks, mutual funds or ETFs. Each has its own unique pros and cons. With individual stocks, you can hand-select which companies to own and which to sell. Additionally, you can choose the timing of your purchases to ensure that you receive qualified dividends.

Mutual funds and ETFs offer instant diversification of your portfolio and professional management that chooses individual companies on your behalf. These funds buy and sell stocks regularly, so you may receive a mix of qualified and non-qualified dividends, as well as short- and long-term capital gains through no fault of your own.

Consistent Track Record

When analyzing potential investments for your dividend portfolio, look for a consistent track record of dividend payments. A company that has paid its dividends every period without fail is often a better choice than one that has started and stopped payouts numerous times. Additionally, companies that regularly increase dividends can help you keep up with inflation and boost your income.

Sector Investing in Your Dividend Portfolio

Some sectors pay dividends more than others. Utilities, telecommunications and consumer staples historically have offered the highest dividend yields. Conversely, small company stocks and technology companies tend to reinvest their earnings so they tend not to offer dividends. Or, if they do, the yields are much lower on average.

Diversification

While you are building your dividend portfolio, don’t forget to diversify your investments. Concentrating your money in one stock or sector can increase risk dramatically within your portfolio. Mutual funds and ETFs automatically provide diversification at the company level, but they can still be concentrated in a particular geography, sector or asset class.

Impact of Inflation on Your Dividend Portfolio

While building your dividend portfolio, one major risk to be aware of is the impact of inflation. Inflation eats away at the value of your income and erodes your purchasing power over time. This is why it is important to select companies that have a history of increasing dividend distributions that outpace inflation.

For example, if you have $100,000 in your dividend portfolio that yields a 4% dividend distribution, you’ll receive $4,000 per year. With a 3% inflation rate, goods and services will cost 50% more within 15 years. If your dividend distributions are not keeping up with inflation, your ability to pay your bills and enjoy your lifestyle could be greatly affected.

Taxes on Dividends in Retirement Accounts

One of the key benefits of holding dividend-paying investments in a retirement account like an IRA or 401(k) is the favorable tax treatment. Unlike dividends in a taxable brokerage account, which may be taxed each year as either qualified (at long-term capital gains rates) or non-qualified (at ordinary income rates), dividends earned within a retirement account are not taxed immediately.

In a traditional IRA or 401(k), dividends grow tax-deferred along with any capital gains. You’ll pay taxes only when you withdraw the money in retirement, typically at your ordinary income tax rate. In a Roth IRA or Roth 401(k), dividends grow tax-free, and qualified withdrawals in retirement aren’t taxed at all.

This makes retirement accounts a strategic place to hold investments that generate a lot of taxable income, such as high-dividend stocks, REITs (real estate investment trusts), or bond funds. By placing these income-generating assets in tax-advantaged accounts, you can minimize the tax drag on your portfolio and keep more of your money working for you.

Conversely, in your taxable account, you may want to focus on investments that are more tax-efficient, such as growth stocks (which don’t pay dividends) or index funds, to keep your annual tax bill lower.

Bottom Line

An investor reviewing their portfolio of dividend-paying stocks.

Building a dividend portfolio involves more than simply choosing stocks with the highest yields. Investors may want to consider dividend consistency, payout ratios, company fundamentals, diversification and the tax treatment of qualified and non-qualified dividends. A well-constructed dividend strategy can provide income while also supporting long-term growth, but it should still fit your broader goals and risk tolerance.

Tips for Creating a Dividend Portfolio

It can be challenging to pick the right dividend portfolio investments, but a financial advisor can help. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Retirees have numerous options when it comes to creating retirement income. A mix of Social Security, pensions, a dividend portfolio and other investments can often meet their needs. Growing your portfolio can generate larger dividends in the future. See how big your portfolio can get using our investment calculator and changing the amounts, timeframe and annual rates of return.