Mar 11, 2022
What Is a Dividend, and How Do Stock Dividends Work?
By Stash Team
In this article:
When you invest in a stock with the intention of making a return on your investment, you may be paying close attention to how much it increases in value. But there’s another way you can make money: investing in dividend stocks. It’s a way to get a slice of the pie when the company earns revenue.
This article walks you through the details you need to understand dividend stocks and incorporate them into your investment portfolio.
What is a dividend?
A dividend is a portion of a company’s profits that they share with their investors. Not all companies pay dividends, And there’s no guarantee any stock will pay dividends in a quarter or year. Those that do issue dividend payments to their shareholders based on the portion of the company those investors own. Dividends can be classified as regular, special, or variable. Dividends may be subject to additional taxes, and are considered taxable income. Please refer to the IRS for additional information.
Types of dividends
When you’re looking to buy dividend stocks, pay attention to the type of dividend offered to understand when and how much your payments might be.
- Regular dividends. This is the most common type of dividend. Companies usually pay a flat amount per share of stock you own, regardless of the company’s financial performance. Generally, dividend payments are issued on a predictable cadence, like once every quarter.
- Variable dividends. Unlike regular dividends, the amount of these payments are determined based on a company’s earnings over a certain time period. They’re often paid on a consistent cadence, but not always. You’ll usually find this type of dividend offered by companies that produce oil, gas, timber, and other such commodities.
- Special dividends. Sometimes, a company will issue a one-time payment in the form of a special dividend. This may be because they’ve been especially profitable and or have a surplus of cash without an immediate need, and they want to share the wealth with investors.
How do dividends work?
When you own a dividend stock, the company will issue payments based on the type of dividend they offer.
First, the company will announce the amount of each dividend and when it will be paid. When they make the announcement, they set a deadline by which investors must own the stock to get the dividend.
If you buy the stock on time, or already own it, you’ll usually receive your dividend payment via your brokerage account. Then you can spend it, save it, or reinvest it. You can also use it to buy more of the same stock, sometimes at a discount, through a dividend reinvestment plan (DRIP), which might be administered by your brokerage or by the company you hold stock in.
Investors who buy and hold their stock typically don’t have to do much to manage their dividends after setting up their initial strategy to spend, save, reinvest, or DRIP.
Last but not least, your stock class can affect your dividends. If you own preferred stock, you may be guaranteed a dividend, but it’s probably a fixed amount. Common stock holders aren’t necessarily entitled to a dividend, but they may receive higher dividends than preferred shareholders when the company’s profits grow.
How are dividends paid?
- Cash dividends. This is the most common way to pay dividends. Usually you’ll receive your cash dividends via your brokerage account.
- Stock dividends. Sometimes companies issue additional shares of stock as a dividend. You should see your additional shares in your brokerage statement.
- Property dividends. Occasionally companies give property as dividends. The process for transferring property depends on the situation.
How often are dividends paid?
Most dividend-paying U.S. companies do so quarterly, with a few paying monthly or semiannually. Non-U.S. companies usually pay dividends once or twice a year. And mutual funds and exchange traded funds (ETFs) typically pay out dividends quarterly or annually.
Want to check how often your stock pick pays dividends? Your brokerage likely publishes a dividend calendar, as do most stock markets, like the New York Stock Exchange and Nasdaq. You can also get information about upcoming dividends in stock charts.
How are dividends taxed?
Whether you keep your dividends as cash or reinvest them, the IRS defines them as income, which means you’ll likely owe tax on them.
The tax rate on your dividends, however, depends on whether the IRS considers the dividend qualified or ordinary. Some dividends are qualified if you hold your shares for 60 to 90 days during a particular window of time and meet other criteria. Other dividends are always considered ordinary, no matter how long you’ve held your shares.
If your dividends are ordinary, you’ll pay the same tax rate as you do on any other income. But the IRS gives you a break if your dividends are qualified; they’re taxed at the lower capital gains rate.
If you have a tax-advantaged retirement account, like an IRA or 401(k), you might own dividend stocks as part of your portfolio. In that case, any dividends you earn are held in the account and treated just like any other investment income. For example, if you have a traditional IRA, you wont pay taxes on your money until you withdraw it after retirement age.
If you own a dividend stock, how much will your payout be? That depends on the number of shares you own and the size of the dividend. Let’s imagine a hypothetical investor and imaginary company to see how it works:
- “Sam” owns 10 shares of stock in “XYZ company.”
- XYZ company pays a quarterly dividend of $0.42 per share.
Sam earns $4.20 each quarter, totalling $16.80 per year. (0.42 x 10 = 4.20 and 4.20 x 4 = 16.80)
Why do companies pay dividends?
Now that you know the practicalities, you might be wondering why a business would want to give away its hard-earned money. The answer: It’s an effective way to attract investors. Dividend stocks are typically offered by established, stable companies. Their stock prices may be relatively flat, so investors aren’t likely to make a big profit from trading their stock. So they can afford to spend some of their profit to entice investors.
Tip: Be aware that businesses can increase, decrease, or eliminate dividends. A small annual increase is common. It’s rare to stop paying dividends, but it can happen.
Companies aren’t required to pay dividends, and many don’t. In fact, you might be surprised to learn that many of the top market players don’t pay dividends. Facebook, Google, and Amazon don’t, and neither does Tesla. Why? Because they don’t need dividends to attract investors. Their stock prices are highly volatile, so people eagerly buy their stock, hoping the share price will soar so they can sell their shares at a profit. What’s more, they need to reinvest their earnings to fuel additional growth.
How to calculate dividend payout
Dividends aren’t just extra cash; they can also be a window into the company’s health. The dividend payout ratio may help you decide whether dividend stock is a good buy for you.
In a nutshell, this figure represents how much a company pays to investors relative to its total earnings. It’s also called a payout ratio. So if a business had a net income of $100 million and paid dividends of $35 million, its payout ratio would be 35%. Some experts say that a 35% to 55% payout ratio is a sign of stability. But a higher payout ratio could indicate that a company is not holding back enough cash to handle an emergency or new opportunities.
Of course, dividend payout ratio is just one indicator of a company’s health. It’s a good idea to research more broadly before investing.
How to invest in dividend stocks
Ready to invest in stocks that pay dividends? You can buy dividend stocks through your brokerage, just like any other kind of stock. Take a look at a company’s stock chart to find out if it pays dividends.
You can also earn dividends from mutual funds or exchange-traded funds (ETFs) that invest in dividend-paying stocks.
How to find companies that pay dividends
If you want to invest in specific dividend stocks, you’ll need to research which companies offer them. These common themes may help narrow your search:
- Established company = more likely to pay dividends. These businesses, while often solidly profitable, aren’t usually growing fast, so their stock doesn’t gain value rapidly. They may need to ice the cake with dividends to attract investors.
- New or rapidly growing company = less likely to pay dividends. Startups and fast-growing businesses often need to invest their profits into growing the business instead of paying dividends. They may also be counting on the potential for their share prices to rise as the primary enticement to investors.
Do dividend stocks have a place in your portfolio?
Dividend stocks can be an important part of a well-balanced portfolio, and reinvesting your payouts may help build your portfolio further. If you want to explore them, you might consider starting out with dividend-focused mutual funds and ETFs, or pick an individual stock or two. As you try out different approaches, you may find your confidence growing, along with your portfolio.
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