How do dividends work?

TL;DR

  • Dividends are payments of cash or additional stock to shareholders
  • Dividends are not required and therefore a company’s board of directors can cut back on or eliminate dividend payments at any time
  • Dividends are often a sign of financial health because they are a product of the company’s excess profits
  • Qualified dividends are subject to a capital gains tax, which is often significantly lower than the federal income tax

What are stock dividends?

When you buy a share of a company, you become a shareholder or partial owner. Often, when a company is doing financially well, it will reward shareholders with regular payments of cash or additional stock, known as dividends. Many refer to dividends as passive income, because the primary prerequisite of receiving a dividend is being a shareholder of a dividend-paying company. Dividends are not a requirement, but rather a courtesy. Therefore, a company’s board of directors can decide to issue, cut back on, or eliminate dividends at any time.

Why do some companies pay dividends and others do not?

There are a few reasons why some companies pay dividends and others do not. Paying dividends is a sign of financial health; dividends signal to investors that the company has excess profits that they are willing to give to shareholders. Therefore, it is not likely that a non-profitable company will offer dividends.

This does not mean that a company’s success is contingent on them offering dividends to shareholders. Young companies often don’t pay dividends because they need to reinvest all excess profits back into the company to fuel high growth. For this reason, you will see that dividends are more common among mature companies.

While dividend payments are often a good sign, it is important to note that extremely high dividend payments could be a red flag. High dividend payouts are extremely difficult to sustain over a long period, so a person who invests in a company with high dividends accepts the risk of the company cutting back or eliminating payments at any time.

How do stock dividends payout?

The timing of a dividend payout differs from company to company. The most common cadence is quarterly, but some companies such as Real Estate Investment Trusts (REITs), pay dividends monthly. The date the company announces that they will be distributing dividends is known as the declaration date. To be eligible to receive dividend payments, an investor must own the share before a pre announced date, or ex-dividend date. If you purchase the share on or after this ex-dividend date you will not receive the dividend payment.

A dividend payment can come in two forms: stock or cash. A stock dividend pays an investor with additional stock. Therefore, if an investor owns 20 shares of a company that promises a 5% stock dividend, the investor will receive 1 additional share as annual dividend payment (5% of 20 is 1). A cash dividend pays investors with cash. Therefore, if an investor owns those 20 shares at $10 apiece ($200 in total value) and the company offers a 5% cash dividend, the investor will receive $10 as annual dividend payment (5% of $200 is $10). On the payment date, you will receive the dividend payment, in either cash or stock, in your brokerage account. Some people choose to pocket dividends, but some people choose to reinvest their dividend payments back into the company. The reinvestment of dividends can be a great way to accumulate wealth.

The way a dividend is paid out is also dependent on whether you are an owner of preferred or common stock. As the name implies, preferred stock shareholders have priority over common stock shareholders. Preferred shareholders usually receive their dividends earlier than common shareholders. Further, if a company decides to skip a dividend payment they may be obligated to pay back this dividend in the future to preferred stock shareholders. They do not have this obligation to common stock shareholders.

Taxing stock dividends 

Whether a cash dividend is qualified or non qualified will determine what tax structure will apply. A dividend is considered qualified if common stock is held for a minimum of 60 days or preferred stock is held for a minimum of 90 days before the ex-dividend date. If a dividend is qualified it is subject to the capital gains tax rate which is considerably less than the federal income tax rate. If a dividend is non qualified, the capital gains tax does not apply and it is subject to the investor’s federal income tax rate.

The capital gains tax rate can either be 0%, 15% or 20% based on your annual income and marital status, whereas the federal income tax rate can fall anywhere between 10% to 37%. Within any income and marital bracket, a person will earn more after a capital gains tax than they would after a federal income tax. Therefore, for the diligent investor, dividends can provide great tax opportunities.

If you receive dividends in the form of stock, taxes do not apply.

What are some dividend-paying stocks? 

Bottom line

Dividend stocks provide passive income for shareholders and can be very lucrative upon reinvestment. While this is not always the case, dividends can signal the financial health of a company to potential investors. Given their association with more mature businesses, some investors may consider dividend stocks to be a safer investment. Keep in mind, dividends are never promised and can be revoked by a company’s board of directors at any time.

Courtney is a freelance writer and finance professional based out of New York City. You can connect with her on Twitter at @CourtSaintJames.

The above content is provided is paid for by Public and is for general informational purposes only. It is not intended to constitute investment advice or any other kind of professional advice and should not be relied upon as such. Before taking action based on any such information, we encourage you to consult with the appropriate professionals. We do not endorse any third parties referenced within the article. Market and economic views are subject to change without notice and may be untimely when presented here. Do not infer or assume that any securities, sectors or markets described in this article were or will be profitable. Past performance is no guarantee of future results. There is a possibility of loss. Historical or hypothetical performance results are presented for illustrative purposes only.

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