How Do Stock Dividends Work?

How Do Stock Dividends Work? article image.

A dividend is a payment certain companies make to their stockholders as a way to share some of the company's profits. Dividends are generally paid on a regular basis, providing shareholders the chance to earn gains on the shares they own without having to sell them off.

If you're interested in receiving dividends, here's what you need to know about how they work, when they're paid and how you can receive them.

How Do Dividends Work?

A dividend is a recurring payment certain companies pay to their shareholders. They're paid out of the company's treasury after it's paid its expenses and reinvested a portion of its profits.

Dividends are generally offered by mature companies that don't need to reinvest as much of their profits toward growing the business. They're often viewed as an indicator that the company's financial performance is sound.

Newer companies and those that are still rapid growth tend not to offer dividends because they're using all their profits to reinvest and spur more growth.

There are several types of dividends you may receive as an investor:

  • Cash dividends: The most common type of dividend is paid in cash directly to your investment account. In some cases, though, you may be able to request a check.
  • Stock dividends: Instead of offering cash, some companies may give you more shares of their stock, which offer more appreciation (and additional dividends) over time.
  • Preferred dividends: If you own preferred stock, which functions as a hybrid between common stock—what you typically think of when you think of stocks—and a bond, you'll receive preferred dividends. They're generally fixed, meaning they pay out the same amount whenever payments are issued (often quarterly). Preferred dividends are paid out before common stock dividends.
  • Special dividends: These are one-off dividends that companies may pay out if they have accumulated profits over time and don't have an immediate need for the money.
  • Dividend reinvestment programs (DRIPs): These are essentially cash dividends, but instead of paying you via your brokerage account, the company uses the money to buy more shares.

Dividend Yield

To get an idea of how much you can expect to receive, you'll look at the stock's dividend yield. This figure shows the stock's annual dividend as a percentage of the price of one share on a certain date.

For example, if you own a stock that's worth $50 and it pays a $0.25 dividend quarterly, that's $1 total for the year. Divide that by the $50 share price, and your dividend yield is 2%. Share prices and dividends can change over time, but many companies consistently maintain high dividend yields, making them attractive investments.

Dividend Payout Ratio

You can also review a company's dividend payout ratio to get an idea of how consistent you can expect the dividends to be. This ratio shows the percentage of the company's net income that goes toward dividend payments.

If the ratio is over 100%, that means the company is paying out more than it's earning, and it will likely be forced to lower its dividend payments in the future or stop making them altogether. Advisors generally view 35% to 55% as a healthy range for a company's dividend payout ratio.

How and When Are Dividends Paid?

With companies that offer them, dividends are typically paid out on a quarterly basis, though some may pay monthly, semiannually or annually.

The process starts when the company's board of directors approves the dividend. The company then announces when the dividend will be paid, how much investors will receive per share and the date by which the stock must have been purchased for it to pay out dividends (the ex-dividend date).

If you purchase the stock on or after the ex-dividend date, you won't be eligible to receive the dividend. But if you sell your shares after that date, you'll still receive the dividend because you owned it on the ex-dividend date.

If you're participating in a DRIP, the money you receive will go directly toward buying additional shares. However, since it's unlikely the math will work out perfectly, you'll typically receive fractional shares instead of whole shares.

What Are the Benefits of Investing in Dividend Stocks?

There are a few reasons many investors prefer to buy stocks that issue regular dividends. Here are some of the disadvantages you can expect:

  • The stock price is relatively stable. Dividends are usually issued by well-established companies that no longer need to invest heavily in themselves to grow. As a result, these companies' stock prices are generally more stable than up-and-coming companies.
  • There's a stable and growing income stream. Dividends can provide regular income in addition to the appreciation in the stock's price. Many companies offer dividends that grow every year, which can help make up for the effect of inflation over time.
  • You can strategize to earn money every month. Companies typically pay dividends on a quarterly basis, but they don't all pay at the same time. So if you're in retirement or you simply enjoy the income stream dividends provide, you can arrange your portfolio in a way that you receive dividend income from various stocks every month.

Are There Risks of Investing in Dividend Stocks?

There are risks inherent in investing in any individual stock, and there are also some potential downsides based on your approach to dividend investing:

  • Stocks are risky in general. Since the 1920s, the stock market has had an average annual return of 10%. But in the short term, stock prices can fluctuate quite a bit—even when it comes to large, established companies. Your financial situation and your personal comfort taking risks should be guiding factors in your investment decisions. Before investing money in the stock market, assess the progress you've made on building your emergency fund, as well as saving for retirement and other goals, such as a down payment on a home. Stock investments are not insured by any bank or government, so don't invest more than you're willing to lose.
  • High yields can be a sign of distress. The idea of getting a high dividend payment relative to a company's stock price is appealing. But a high dividend yield isn't sustainable if the company can't be able to afford funding dividends.
  • Dividend stocks are vulnerable to interest rate increases. As interest rates go up, dividends become less attractive to experienced investors, especially if they can get a better return by investing in risk-free Treasury bills.

Investing in stocks can be risky, but one way to reduce some of the risks you might face with a single stock is to invest in dividend-focused exchange-traded funds (ETFs). These funds pool money from several investors to buy a wide variety of dividend-offering stocks. That diversification is a way for investors to mitigate risk.

How Are Dividends Taxed?

Dividend income is considered taxable, but how it's taxed depends on a couple of factors. First, dividends can be either qualified or nonqualified. Also, your income bracket will help determine how much you pay.

Qualified vs. Nonqualified

Qualified dividends are taxed as long-term capital gains, which is a lower rate than what you pay on your ordinary income. Nonqualified dividends, on the other hand, are taxed at the ordinary rate.

In order to be eligible as a qualified dividend, it must be paid by one of the following:

  • A U.S. company
  • A company in U.S. possession
  • A foreign company residing in a country that's eligible under a U.S. tax treaty
  • A foreign company whose stock can be easily traded on a major U.S. stock exchange

Additionally, you need to meet a holding period requirement. For common stock, you must hold your shares for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date.

Income Bracket

Both ordinary income and capital gains tax rates are determined by the tax brackets that apply to your income. Work with a tax professional or review the latest tax brackets on the IRS website to understand how much you'll pay.

Get Your Financial Foundation Ready Before Investing

Investing can help you increase your income, but it should take a backseat to other important financial fundamentals. Take some time to build an emergency fund so you can weather financial rainy days when they occur. And consider paying off high-interest debt, including credit cards, before you get into investing. It's also a good idea to consider checking your credit score, and looking for ways to improve it, so you can save money on loans and credit cards.

Even with the prospect of big returns and dividend income, you'll typically get more value by eliminating high-interest debt. You'll also be doing yourself a favor considering your long-term financial future before making potentially risky investments in the stock market.

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