A top guide to dividend investing must include some of the lesser-known parts of a successful dividend strategy, including DRIPs and tax benefits

You pay tax on dividends in the year you get them, if you hold the shares in a cash account and outside of your RRSP, RRIF or TFSA. However, dividends on Canadian companies held outside of one of those registered accounts receive favourable tax treatment in Canada, thanks to the dividend tax credit. (Note that where you hold your Canadian dividend-paying stocks depends not just on the availability of the tax credit, but also on what else you hold in your portfolio.)

This dividend tax credit—available on dividends paid on Canadian stocks held outside of an RRSP, RRIF or TFSA—will cut your effective tax rate. This means that dividend income will be taxed at a lower rate than the same amount of interest income.  Discover more in our guide to dividend investing below.

Invest in your Financial Future for FREE Learn everything you need to know in '9 Secrets of Successful Wealth Management' for FREE from The Successful Investor. Secrets of Successful Wealth Management: 9 steps to the life you've always wanted, before and after retirement.  I consent to receiving information from The Successful Investor via email. I understand I can unsubscribe from these updates at any time.

 Guide to dividend investing: Here are the pros and cons of DRIPs

Dividend Reinvestment Plans (DRIPs) have attractive features, but they shouldn’t be the sole reason you invest in a stock—or limit yourself to a portfolio of stocks that offer DRIPs.

Some companies provide dividend reinvestment plans, or DRIPs, that let shareholders receive additional shares in lieu of their cash dividends. DRIPs don’t require the participation of brokers—they can be set up directly with the company—so shareholders save on commissions.

DRIPs also eliminate the nuisance effect of receiving small cash dividend payments. Second, some DRIPs let you reinvest your dividends in additional shares at a discount (say, 3% or 5% for example) to current prices. Third, many DRIPs also allow optional commission-free share purchases on a monthly or quarterly basis.

Generally, investors must first own and register at least one share before they can participate in a DRIP. Registration will generally cost $40 to $50 per company. The investor must then notify the company that he or she wishes to participate in the company’s DRIP.

There are also separate dividend reinvestment plans that are available through most discount brokers (these are called “synthetic DRIPs”). Under these plans, brokers will reinvest dividends on shares that you hold in your account. However, not all your dividend stocks may be eligible for these plans, and you need have a total dividend payment large enough to buy a full share of stock.

Overall, we think that dividend reinvestment plans are okay to participate in. But we think there are a few important points to keep in mind:

1. Many investors make their investment choices solely on the basis of the existence of the DRIP option. We think the availability of a DRIP is only a bonus, rather than a reason to invest by itself. Investing only in stocks that offer DRIPs limits both investment choice and opportunity.
2. The advent of the low-cost discount brokerage and online investing has reduced the commission cost of investment trades. Thus, the commission-free investing that DRIP investing allows is less of an advantage today than it was in the past.
3. Taxes are still payable on dividends that are reinvested.

Guide to dividend investing: High yields can be a danger sign

When looking for stocks with high dividend yields, you should avoid the temptation of seeking out stocks with the highest yield—simply because they have above-average yields.

That’s because a high yield may signal danger rather than a bargain if it reflects widespread investor skepticism that a company can keep paying its current dividend. Dividend cuts will always undermine investor confidence, and can quickly push down a company’s stock price.

Above all, for a true measure of stability, focus on stocks that have a high dividend that they have maintained or raised during economic or stock-market downturns. That’s because these firms leave themselves enough room to handle periods of earnings volatility. By continually rewarding investors, and retaining enough cash to finance their businesses, they also provide an attractive mix of safety, income and growth.

A track record of dividend payments is a strong sign of reliability and a strong indication that investing in the stock will be profitable for you in the future.

Guide to dividend investing: Here are some tips to determine the sustainability of a company’s payout

• Look for companies with long-term success. These companies are the most likely to keep paying and increasing their dividends.
• The current financial health of a company. If a company is doing well, has done so consistently, and shows signs of growth, these factors are indicative of stocks that will keep paying a dividend.
• A company’s current dividend. If a stock currently offers a healthy dividend, this is a good sign of its potential to continue offering a steady dividend.
• Note the competition. Look for companies with a strong hold on a growing market and a unique product or service that cuts its competition.

Use our three-part Successful Investor approach as a guide to dividend investing profitably

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

What do you feel a guide to dividend investing would need to include in order to be complete?