What are dividends, and how do they work?

If you’re a stockholder, you’ve likely felt the rush of adrenaline as you watch the value of your portfolio surge.

But the market doesn’t always go up. Sometimes it goes up and then spikes down, and other times it’s like riding a violently rocky ship, crashing through the waves. If the rocky waters scare you, you may decide that focusing on dividends, rather than capital gains, as a source of return may make more sense for you.

But what exactly are dividends, and how does this source of income work?

This post will explain what dividends are, how they work and are paid out, why companies choose to pay dividends, if taxes are paid on them, and more.

What are Dividends, and How Do They Work?

Dividends are corporate monies paid out to shareholders, often every quarter, for holding ownership in the company. When a company has additional money in their coffers, they sometimes like to pay it out to shareholders as thanks for investing in the company.

Dividends are paid per each share of stock you own. For example, if you own 100 shares of company X and their dividend pays $.02 per share, you’ll earn $2 in dividends every time they issue a dividend. It’s important to know that not all companies pay dividends. In addition, there are multiple types of dividends.

Types of Dividends

There are two types of dividends: qualified and unqualified.

  • Qualified: This is the most common type of dividend. These are dividends from regular corporations, such as Nike, Apple or Amazon, and are subject to tax at the long-term capital gains tax rate. If you invest in the stock market or ETFs, the dividends you receive are likely qualified.
  • Unqualified: These dividends, also called ordinary dividends, are less common, and are associated with real estate investment trusts (REITs) or employee stock options. These are taxed at regular federal income tax rates.

The main difference between the two types of dividends is the tax rate you will pay.

Do You Pay Taxes on Dividends?

Yes. Because dividends are considered income, investors have to pay taxes on them – though not everyone pays the same tax rate. Rates will differ depending on how much income you make, the types of dividends you received and how much you made from them.

  • Qualified dividends: These dividends are taxed at the long-term capital gains tax rate, which, for single filers in 2020, is:
    • $0 to $9,875 – 0%
    • $9,876 to $40,000 – 0%
    • $40,001 to $40,125 – 15%
    • $40,126 to $85,525 – 15%
    • $85,526 to $163,300 – 15%
    • $163,301 to $207,350 – 15%
    • $207,351 to $441,450 – 15%
    • $441,451 to $518,400 – 20%
    • $518,400 and up – 20%
  • Unqualified dividends: These dividends are taxed at the ordinary federal income tax rate, which, for single filers in 2020, is:
    • $0 to $9,875 – 10%
    • $9,876 to $40,000 – 12%
    • $40,001 to $40,125 – 12%
    • $40,126 to $85,525 – 22%
    • $85,526 to $163,300 – 24%
    • $163,301 to $207,350 – 32%
    • $207,351 to $441,450 – 35%
    • $441,451 to $518,400 – 35%
    • $518,400 and up – 37%

When you’re getting ready to file your taxes for the previous year, you’ll get a form from your brokerage firm called a 1099-DIV. This form will list the dividends you received and their amounts. You’ll enter this into your 1040 as income on lines 3a (qualified) and 3b (ordinary). If you received less than $10 in dividends during the year, you may not receive a 1099-DIV – you should still report this income on your taxes.

How are Dividends Paid?

Dividends are paid automatically into an investor’s account, usually a brokerage account. Depending on the type of investment, this may be issued quarterly or monthly. Sometimes it’s paid as cash and other times it’s in the form of additional shares of stock, particularly if you’re using a DRIP function (more on that below).

The paying of dividends follows a strict schedule:

  • Dividend Declaration Date: First, the company declares they are paying shareholders a dividend. (This is decided by a board of directors, who also determine how much is being paid out, to whom, and by when.)
  • Ex-Dividend Date: Then, the company decides who will receive the dividend. This is determined by the ex-dividend date. Shareholders who held the stock before the ex-dividend date will receive the dividend. Shareholders who purchased the stock after the ex-dividend date will not receive it. Shareholders who no longer own the stock but held it before the ex-dividend date are still entitled to receive the dividend.
  • Record Date: This is the date the company will determine who is going to actually receive a dividend.
  • Payment Date: This is the date when the payment is paid out to shareholders.

Why Do Companies Pay Dividends?

Companies pay dividends to shareholders for a number of reasons:

  • Reward investors: Companies like to reward investors for investing in their company.
  • Project an image: Companies who regularly pay out dividends are projecting that they’re successful, have capital to spend and don’t need to invest all funds further into the company.

Why Don’t Companies Pay Dividends?

Conversely, there are a number of reasons why a company may not pay a dividend:

  • Not enough capital: Some companies don’t make enough money to pay out dividends to shareholders.
  • Want to reinvest in the business instead: Many industries, such as the pharmaceutical industry, like to reinvest their earnings into additional research so they can grow their business.

How to Determine if a Dividend Stock is Good?

Dividend investors use a few different pieces of data to determine if a company is a good dividend stock.

  • Increasing earnings: A company’s profits are a good place to start when determining if you should support them. After all, if a company isn’t growing and making money, can they really be considered a good business?
  • Strong cash flow: Strong cash flow indicates a company is making enough money to put in its reserves, which it can then use to pay back debt, distribute to shareholders, invest in the business, pay expenses and more. Having positive cash flow indicates the business is liquid, flexible and describes its overall financial performance.
  • Cash dividend payout ratio: This ratio is used to evaluate whether a company’s dividend payment is sustainable or not. The lower the value, the more likely the company can continue to pay out the dividend without stretching the company too thin.
  • Low debt to equity ratio: This ratio is an expression of debt a company has compared to its equity. The lower the ratio, the better. For example, if a company has $125,000 worth of assets and has $100,000 worth of debt, their equity is $25,000. Therefore, their debt to equity ratio is 4. This is considered relatively high risk and shows that the company may be overleveraged. In general, it’s recommended to avoid companies that have a debt to equity ratio of 2 or more.
  • Industry strength: It’s important to keep changing trends and the economy, as well as supply and demand, in mind. For example, as people become more health conscious, investing in soda and snack companies, even the most popular like McDonald’s and Coca-Cola, may not be as profitable as it used to be. On the other hand, investing in healthcare companies, especially with an aging population on the rise, may make in smart financial sense.

Dividend Aristocrats

There is a special crop of companies that are known as “dividend aristocrats”. A company earns this distinction by not only paying a dividend every year for the last twenty-five years, but by increasing their dividend yield every year as well.

They come from many different industries, such as consumer staples, healthcare and industrial sectors, and are typically the most well-known and profitable companies around the world.

An example of dividend aristocrats are:

  • AT&T – 34 years
  • Chevron – 31 years
  • Coca-Cola – 56 years
  • ExxonMobil – 36 years
  • Kimberly Clark – 46 years
  • McDonald’s – 42 years
  • PepsiCo – 46 years
  • Procter & Gamble – 56 years
  • Sysco – 38 years
  • Target – 47 years

Investors love dividend aristocrats because they are seen as relatively safe investments, as they are typically leaders in their field, generate large amounts of profits, and by virtue of being an aristocrat, have managed to stay relevant in an ever changing economy.

Investing in Dividend-Paying Investments

Stocks are one of the main ways investors receive dividends, but you can also collect dividends from the following investment vehicles:

  • Mutual Funds: A mutual fund is an investment vehicle in which investors pool their money together and a manager decides how to invest it. Mutual funds can invest in stocks, bonds, a balanced portfolio of both and money market funds. Funds that invest in stocks and bonds that pay a dividend will typically pass on that dividend to investors.
  • ETFs: Exchange trades funds are similar to stocks in that they’re traded on the stock market, but instead of investing in single companies, the fund invests in hundreds or even thousands of companies. This greatly minimizes risk because you’re highly diversified. Funds that invest in stocks and bonds that pay a dividend will typically pass on that dividend to investors.
  • REITs: An REIT, also called a real estate investment trust, is like a mutual fund for real estate. Investors pool their money together and a manager decides how to invest it. There are REITs in a diverse number of categories, including residential, office, healthcare, industrial, retail, infrastructure, and more. REITs allow small-time investors to invest in real estate assets without having to actually purchase them. Investors love REITs because they diversify your portfolio, provide stable income in the form of dividends and have great tax benefits.

DRIP Investing

There is also a form of dividend investing called “DRIP investing”, in which dividends you receive are automatically reinvested for you by your brokerage firm. When you receive a dividend, instead of it being issued into your brokerage account, it’s reinvested by purchasing additional stock.

This is super helpful as it’s done automatically, and charges no fees or commissions to do so. It also allows you to purchase fractional shares, meaning if the dividend issued isn’t big enough to purchase an entire share, it can still buy part of one. Over time, this additional money compounds in your account and can lead to additional hundreds, or even thousands of dollars.

Final Thoughts

Investing in companies that regularly pay a dividend can be a great strategy to employ for investors, especially if income is more important to you than capital gains. Using valuation measures such as P/E ratio can help you build a diverse portfolio of dividend paying assets that can help you reach your financial goals.

It’s important to remember that not all companies pay out dividends, and the ones that do could change that at any moment. But if you want to increase your yearly income while looking to lower volatility, investing in dividend stocks may be the right move for you.

Sign up with one of our favorite brokerage firms today to get started!

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