Investing Basics: What Are Dividends? (2024)

A dividend is a payment in cash or stock that public companies distribute to their shareholders. Income investors prefer to earn a steady stream of income from dividends without needing to sell shares of stock.

Understanding Dividends

Dividends are how companies distribute their earnings to shareholders. When a company pays a dividend, each share of stock of the company you own entitles you to a set dividend payment. Dividends can be cash, additional shares of stock or even warrants to buy stock.

Both private and public companies pay dividends, but not all companies offer them and no laws require them to pay their shareholders dividends. If a company chooses to pay dividends, they may be distributed monthly, quarterly or annually. Special dividends are paid on an irregular basis.

Even among companies that do pay dividends, not all shareholders are eligible to receive them equally. Preferred and common stock, as well as different classes of stock, typically earn varying dividends or none at all. Preferred stock generally has a stronger claim to dividends than common stock, for instance.

Special Dividends

A special dividend is a one-time bonus dividend payment. Special dividends might be one-off payouts from a company that doesn’t normally offer dividends, or they could be extra dividends in addition to a company’s regularly scheduled dividends.

Companies generally announce special dividends when they’ve been especially profitable and want to share earnings among shareholders. Special dividends are not a commitment by a company to continue offering dividend payment at that rate. For example, Microsoft paid a one-time dividend of $3 per share in 2004, equal to $32 billion. Its regular quarterly dividend rate remained 13 cents per share.

Stock Dividends

A stock dividend is a dividend paid as shares of stock instead of cash. You can sell these dividend shares for an immediate payoff, or you can hold them. A stock dividend functions essentially like an automatic dividend reinvestment program (more on that below).

When Are Dividends Paid?

Dividends may be paid on a monthly, quarterly or yearly basis, depending on the company. There are three key dates to know when it comes to dividends: the declaration date, the ex-dividend date and the payment date.

• Declaration date.This is the date on which the company’s board or management team announces a dividend will be paid. The board then votes on whether to pay the dividend.
• Ex-dividend date.This is the date on which you must own a dividend-paying stock in order to receive the dividend. The ex-dividend date is normally one business day before the company checks its stockholder roster to determine who gets a dividend. If you buy shares on or after the ex-dividend date, you won’t receive the related dividend payment. Conversely, if you sell your shares on or after the ex-dividend date, you will still receive the related dividend payment.
• Payment date. This is the day shareholders who held a stock on the ex-dividend date receive their dividend payment.

In general, if you own common or preferred stockof a dividend-paying company on its ex-dividend date, you will receive a dividend.

Which Stocks Pay Dividends?

Stocks that commonly pay dividends are more established companies that don’t need to reinvest all of their profits. For example, more than 84% of companies in the S&P 500 currently pay dividends. Dividends are also more common in certain industries, such as utilities and telecommunications.

Many companies pride themselves on paying dividends regardless of market conditions or other factors. Many investors, particularly retirees, may try to invest primarily or solely in such dividend-paying stocks.

On average, dividend-paying stocks return 1.91% of the amount you investin the form of dividends,which can provide a higher return than some high-yield savings accounts. Dividend stocks do not offer the same security of principal as savings accounts, though.

Dividends for Mutual Funds and ETFs

Because they often own dividend stocks, mutual fundsand exchange-traded funds (ETFs) may distribute dividend payments to their shareholders. If you own an ETF or mutual fund, you’ll receive your portion of the fund’s dividend income based on the number of shares you own and the company’s representation in the fund. An S&P 500 fund, for example, might pay a dividend yield of 1.77% while some companies within the S&P 500, like Kohl’s, offer dividend yields above 13% (more on yields below).

Dividends and REITs

A real estate investment trust (REIT) owns or operates income-producing real estate. To be classified as a REIT, 90% of the taxable income these companies earneach year must be paid out in the form of dividends, and 20%of those dividends must be paid as cash.

These traits make REIT stocks attractive choices for investors who want reliable dividend income and high yields. REITs offer an average dividend yield of 3.8%, more than double what you might get from an S&P 500 fund. REITs focusing on certain sectors, like mortgages, may even offer higher yields.

Common Stock Dividends vs Preferred Stock Dividends

There are two main types of stock: common stock and preferred stock. Everyday investors who invest in individual stocks usually hold shares of common stock.

While shares of common stock always have voting rights, if they offer a dividend it isn’t guaranteed. Even if a company has been paying common stock dividends regularly for years, the board of directors can decide to do away with it at any time.

Preferred stock, on the other hand, usually has a greater claim to dividends. While they don’t have voting rights, preferred stockholders are more assured of receiving dividends at a set rate and are prioritized to receive dividend payments before common stockholders. These regular, set payments mean that preferred stocks function similar to bonds.

Preferred stock prices are generally also consistent like bond prices and may not offer the potential for growth that most common stock does. However, in the event a company goes bankrupt, preferred stockholders receive payments before common stockholders. Any company bondholders, however, are paid before preferred stockholders.

What Is Dividend Yield?

Dividend yield is a way of understanding the relative value of a company’s dividend payment. Yield is expressed as a percentage, and it lets you know what return on investment you’re making when you earn a dividend from a given company.

Since dividends are paid as a set amount per share, it can be difficult to compare dividend payments across companies given their different share prices. Dividend yield provides an handy way to measure and compare which stocks pay the most dividends per dollar you invest.

How to Calculate Dividend Yield

To calculate dividend yield, divide the stock’s annual dividend amount by its current share price.

Let’s say the stock ABC is trading at $20 per share, and the company pays a quarterly dividend of 10 cents per share. For the year, ABC’s dividend would be 40 cents. Divide 40 cents by $20 per share to arrive at a dividend yield of 2%.

Dividend yield lets you compare the value of dividends from different companies. Stock XYZ, for example, might pay a higher quarterly dividend than ABC of 20 cents per share, for a total annual dividend of 80 cents. Since shares of XYZ are valued at $75 per share, though, the dividend yield is only 1%.

The dividend yield you’d earn from owning shares of ABC is better than XYZ’s—at least until the shares’ values or dividends change.

How Are Dividends Taxed?

Dividends are taxed based on whether they’re qualified dividends or ordinary dividends.

• Qualified dividendsare dividends from U.S. companies or foreign companies trading on a major U.S. stock exchange. Qualified dividends may also be from companies in U.S. possession or companies that are located in countries with a U.S. tax treaty. In general, if you own shares of a U.S. stock that pays dividends, you’re eligible for a special tax rate.
• Ordinary dividends, or unqualified dividends,are dividends from foreign companies that don’t meet the above specifications, as well as dividends you receive from REITs, employee stock benefits or tax-exempt companies as well as interest from savings accounts and checking accounts.

How Are Qualified Dividends Taxed?

Qualified dividends receive preferential tax treatment that may be lower than your regular tax rate. The taxes you pay on qualified dividends is determined by your tax bracket:

• If you’re in the 10% or 15% bracket, you don’t pay taxes on qualified dividends.
• If you would normally be taxed at 15% but less than 37%, you pay 15% on any qualified dividends received.
• If you’d normally be taxed at the 37% rate, you pay 20% on any qualified dividends.

How Are Ordinary Dividends Taxed?

Ordinary dividends are taxed at your regular income tax bracket, just like short-term capital gainsor your paycheck.

How Do Dividend Reinvestment Plans Work?

A dividend reinvestment plan (DRIP) automatically purchases new whole or fractional shares of a stock when you receive its dividend.This is particularly helpful because it may increase the amount of dividends you receive in the future. Here’s how:

Let’s say you receive $20 as a dividend one quarter. If the stock price is at $20 per share, you end up getting an extra share of the stock. Next time dividends are paid out, the amount you receive will be based on the new number of shares you have, which includes your share purchased last quarter using a DRIP. This means your dividend payment will be slightly higher than it would have been otherwise.

With dividend reinvestment, you start a cycle of continuously buying more shares, which results in the ability to get a higher dividend payment next time, which in turn gives you the potential to buy more shares. This kind of compounding is why dividends accounted for 42% of the total return of the S&P 500 from 1930 to 2019, according to an analysis by Hartford Funds.