By Bruce W. Fraser, Contributor to Wealth Management Exchange

With 2008 approaching, this could be a good time to add a few dividend-paying stocks to your portfolio. Dividend paying stocks are especially suitable for those preparing for retirement, as a way to combat inflation and as a hedge against other declining investments.

Blue chip companies such as GE, Bank of America and Citigroup pay out billions of dollars each quarter, according to Standard & Poor's. Financial stocks in the S & P 500 Index have accounted for approximately 30.5 percent of the most recent dividend payouts, even though they make up only 19 percent of total S&P 500 Index companies, S & P notes. "Practically all the financials (in the index) have the best record of dividend increases traditionally," says Howard Silverblatt, senior index analyst at S & P. It remains to be seen whether this growing dividend trend will continue in light of the subordinated debt crisis and massive write-offs by many of these financial services companies.

The combination of a consistent dividend with an increasing stock price is a powerful combination. As some have pointed out, as nice as a growing dividend is from a yield perspective, it's even more powerful as an indicator of management's confidence in the continued earnings power of the company.

Tax Benefits Extended

The traditional tax penalty for dividend stock vs. growth stocks has also been removed. Dividend stocks, with a few exceptions, are now taxed at just a 15 percent rate for taxpayers in the highest federal tax brackets, the same rate that applies to long term capital gains.

Congress extended the 15 percent tax rate on long-term capital gains and qualified dividends through 2010. It had been scheduled to expire after 2008. For your capital gains to qualify as long term, you must have held an asset for more than one year.

Historically, dividend stocks have provided good performance and actual income and cushioned the blow to declining stock prices. They have also accounted for about 40 percent of the historical 10 percent annual return of the stock market.

We asked Don Schreiber Jr., CFP, co-author of "All About Dividend Investing," www.allaboutdividends.com, and president of Wealth Builders Inc., Little Silver, NJ www.imawealthbuilders.com, to explain the ins and outs of dividend investing:

Q. What are the benefits of dividend investing to wealthy investors?

A. With the dividend tax cut, dividends are back in favor and many companies are making their stocks more attractive to dividend hungry investors. According to data supplied by Ned Davis Research, since 1972, dividend-paying stocks in the S & P 500 Index have gained an average of 10.30 percent per year, compared with 2.40 percent for non-dividend stocks.

We believe we are in the seventh year of a 17-20 year underperformance cycle, where the rate of return from price appreciation on domestic equities will be less than the historic average investors have come to expect over the past 100 years. According to S & P, the return of dividends during underperformance cycles has contributed more of the total return. According to Standard and Poor's, from January 1926 to December 2006 the rate of return for the S & P 500 averaged 10.50 percent while dividends accounted for 40.63 percent of that return. Also, according to Ibbotson, dividends accounted for 44 percent of the Dow's return during that same period of time.

Q. How does an investor pick dividend paying stocks? What are the most important criteria?

A. When accessing dividend stocks, look for stocks with yields at least one- and- a- half times the average yield of the S & P 500, at least $1.20 of cash flow per share for every $1.00 of dividend, and a history of raising the dividend. For a growth stock, that would be two times the average for an income stock.

Determine the dividend yield you want. For our dividend growth and income portfolio we set our minimum required dividend yield at 150 percent of the S & P 500 Index dividend yield, currently approximately 1.8 percent. This means our screening process would only pass stocks with a yield greater than 2.70 percent. Investors who are more income oriented may want to set their minimum yield criteria somewhat higher, or about 2 times the S & P 500 Index dividend yield. (3.6 percent).

Investors should also look for stocks that are cheap. From a historical perspective, a price-to-earnings ratio shows reasonable value, 8 would be indicative of bear market value, and 20 would be overvalued. We look for rising earnings and revenue, which generally indicates a positive trend for the company.

Q. Why are high yields so important?

A. Higher yielding stocks tend to outperform lower yielding stocks over time. The S & P High-Yield Dividend Aristocrat Index (3.3 percent yield) had a five-year annualized return for the period ending 2005 of 14.6 percent instead of –1.5 percent for the lower yielding S & P 500 Index. The higher yielding index provided a higher return with about 30 percent less risk with a standard deviation of 10.9 percent to 15.3 percent for the S & P 500 Index.