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Understanding the Basics of Dividends

Understanding the Basics of Dividends

While investing in stocks has proven to be the best and easiest way for the average investor to accumulate wealth over the long term, holding stocks with dividend payouts is often overlooked to help reach that goal.

A dividend is the distribution of a portion of a company's profits. By knowing how dividends work, you can own these types of stocks for your long-term benefit. Here's what you need to know about dividend-paying stocks.

Definition of dividend

Companies may choose to periodically reward their shareholders by paying dividends, usually in cash or, rarely, in shares. Companies that consistently generate more profit than management can effectively reinvest in the business often choose to start paying dividends.

Companies typically pay one of three types of dividends:

  • Regular dividend: this type is the most common. Companies that pay a regular dividend pay it consistently over time, partially calibrating the dividend amount to ensure it's affordable in good and bad years. Regular dividends are usually paid quarterly, but they can also be paid monthly, semi-annually, or annually.

  • Special dividend: this type of dividend is a single payment. A business may choose to pay a special dividend after a series of very profitable quarters or because the business has sold an asset and does not have immediate use of the money. Some companies pay special dividends because they have accumulated cash over time, which the company does not need to maintain operations. Companies often publicly announce special dividends to let the market know that they intend to send money to shareholders. Still, shareholders should not expect the payment to become a recurring event.

  • Variable dividend: Companies that produce goods, such as oil and gas or timber, sometimes choose to pay a variable dividend in addition to paying regular dividends. Variable dividends tend to be paid at reasonable intervals but vary based on the company's earnings for the quarter or the previous year.

Companies that pay dividends are valued based on the annual dividends paid against the company's stock price, known as the company's dividend yield. A stock that pays an annual dividend of $0.50 per share and trades at $10 per share has a 5% dividend yield.

Dividend income allows investors to quickly assess how much they could earn in dividends by investing a certain amount of money in a stock. If a stock has a 5% return, you know you will earn $5 for every $100 invested, $50 for every $1000 invested, and so on. Dividend income also allows you to compare a stock with other income investments, such as certificates of deposit or bonds.

Why do companies pay dividends?

Not all companies pay dividends, but many do. About 75% of S&P 500 companies pay regular dividends.

Large, slower-growing companies are more likely to pay dividends to their investors than smaller, faster-growing companies. Growing companies must hold onto their profits in order to continue to grow, while large consolidated companies are already profitable. Most companies with a lot of money on their hands choose to pay dividends.

How are dividend amounts determined?

Companies that pay dividends tend to develop a dividend policy over time that guides the amount payable to shareholders. The amount of the company's dividends each quarter is voted on and must be approved by the company's board of directors.

When are dividends paid?

Most companies that pay regular dividends do so quarterly. Once the board of directors has agreed on the dividend payment amount, the company officially declares the next dividend. This day is known as the date of the declaration.

On the declaration date, the company also indicates a date known as the registration date. You must be a shareholder of the company to receive payment of the declared dividend. The establishment of the record date determines the ex-dividend date, i.e., the first day on which the shareholders who bought the shares will not be entitled to receive the declared dividend. The ex-dividend date is one business day before the registration date.

The payment date is the date on which the dividend payment is paid to the shareholders. If a shareholder receives a dividend by mail, dividend checks will be mailed on the payment date.

How are dividends taxed?

If you hold dividend-paying stocks in a taxable brokerage account, the dividends you receive are taxed as regular income or eligible dividends. "Eligible" dividends are taxed at lower rates on long-term capital gains.

If you hold dividend-paying stocks in a subsidized account, you are not taxed on the dividends received. Here are some types of accounts that exempt you from dividend tax until you withdraw money from your account:

  • 401(k) plan

  • Coverdell Education Savings Account (ESA)

  • Roth IRA

  • A simplified employee pension (SEP) IRA 

  • Traditional individual retirement account (IRA)



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