Dividend-paying investments always have provided benefits. Now they can be even more appealing in light of the lower taxes rates at which dividends are taxed.

Lower tax rates for dividends have been extended until the end of 2010. Prior to the lowered rates, dividends from stocks and stock mutual funds were taxed at your ordinary income-tax rate. The highest income-tax bracket currently is 35%. Now you pay taxes on qualified dividends at the long-term capital gain rate of either 5% or 15%. And in 2008, you will pay taxes at a rate of either 0% or 15%, depending on your income-tax bracket.

How Dividends Work

Companies share profits by making cash payments in the form of dividends. Stock mutual funds that receive dividends from the companies they invest in are required to pass them along to fund investors after deducting management fees and other charges. Dividends usually are paid at a regularly scheduled time, such as quarterly, semiannually or annually.

Qualified dividends, as defined by the IRS, primarily are dividends paid on stock investments. Bond and money market mutual funds refer to the income they pay investors as "dividends," but these dividends actually are generated by interest income. Because they are not considered qualified, they will be taxed at your ordinary income-tax rate.

To pay taxes on qualified dividends at the long-term capital gain rate, you must hold the mutual fund shares for 61 days or longer. That period must include the date the fund distributes the dividends.

Benefits of Dividend-Paying Investments

Investors tend to view companies that pay dividends as generally healthy. When companies pay dividends, it indicates they can afford to share profits. A company's dividend history is a good indication of its willingness to both share profits and demonstrate accountability to investors. In periods of market uncertainty, these qualities may become especially appealing to investors.

If a company increases its dividend each year, it's a good sign that the company is optimistic about its future growth. This positive sign, in turn, can generate investor interest in a company, which could potentially increase a company's stock price.

Stocks of companies that pay dividends generally have lower price volatility than stocks of companies that don't pay dividends, according to data from Ibbotson Associates, a Chicago research firm. The dividend creates a cushion and smoothes out a stock's price volatility because it's one of two elements of total return.

The other component is share price, which can increase or decrease. If a company's share price declines but the company issues a dividend, the dividend helps offset some of the decline in total return. Similarly, dividend-paying investments may not experience the same increase in share price as non-dividend-paying investments.

Reinvested Dividends Add Up

Dividends that are reinvested provide an opportunity to help your investment grow over time. For example, if you invested $10,000 in S&P 500 stocks in 1986 and didn't reinvest your dividends, your account would have been worth $61,320 20 years later. However, if you had reinvested the dividends paid on those stocks, your account value would be $98,0931.

Dividends for some stocks may amount to only a few pennies per share, but they add up. Keep in mind that the value of this contribution could fluctuate depending on stock market conditions.

Dividend-paying investments can add diversification to your portfolio and help minimize volatility. However, it is possible to lose money by investing in them. Be sure to meet with your tax or investment advisor to determine which investments are suited to your goals and objectives.

1The S&P 500 Index is a capitalization-weighted index of 500 widely traded stocks. Created by Standard & Poor's, it is considered to represent the performance of the stock market in general. It is not an investment product available for purchase.

Past performance is not a guarantee of future results.

IRS Circular 230 Disclosure: American Century Companies, Inc. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with American Century Companies, Inc. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties.

This information is for educational purposes only and not intended as tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.