What Are Dividends and How Do They Work?

One of the best ways to build long-term wealth is to invest our money in dividend-paying stocks in the stock market rather than stashing it away in a savings account. You can invest in a variety of different types of assets like stocks, bonds, real estate, and dividends. These are all called assets, and they appreciate in revenue (grow in value) while also providing opportunities to earn supplemental income.

Dividend stocks are a popular way for investors to put their money to work while generating income from it. Companies pay dividends by redistributing the company’s profits to shareholders. While not all companies pay it, some do and they can help boost your portfolio.

In this article, we’ll dive into what dividends are, how they work, and a few important things you should know before investing in them.

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What Are Dividends?

Some companies reinvest their profits into growing the company while others share their profit with investors. When a portion of a company’s profits is shared with investors they’re called a dividend.

These are an opportunity for investors to earn extra income that is separate from a stock’s value. When you hold dividend-paying stocks, the value of the stock can increase alongside whatever dividend you earn. Depending on your investment strategy, you can either keep dividend payments as cash or you can reinvest them to grow your portfolio.

Dividends are paid at regular intervals, typically each month or once a quarter. Some may pay these just twice a year. Not all companies pay dividends, but some companies, like Real Estate Investment Trusts (REITs) are required to by law. Whether or not a company pays a dividend comes down to its growth strategy. Some offer dividends to appeal to investors, while others reinvest profit into growing the company, choosing to increase the overall value of the stock instead. 

One of the main draws of holding stock from dividend-paying companies in your portfolio is that it can provide a predictable and recurring source of income. This kind of income can be particularly helpful when planning for your retirement.

That being said, dividends aren’t permanent. They can change depending on a company’s profitability or the state of the economy. Some companies may choose to increase dividend payments over time if the company is doing well while others may pull back these payments if they’re worried about economic uncertainty. The decision about when to change the payment and by how much is ultimately made by the board of directors.

Terms to Know

Before getting started investing in dividend stocks, there are a few key terms you should know: 

• Dividend per share: The amount that a company pays out per share of stock owned. Coca-Cola, for example, currently pays $0.46 per share. That means if you own 1,000 shares of Coca-Cola stock, you’ll earn $460 per quarter in dividend payments, or $1,840 per year.
• Dividend yield: The annual dividend per share price divided by the share price. It tells you how much income you can expect to earn over a year and allows you to compare options across different companies. Put another way: it shows the return on investment you can expect to make from the stock.
• Ex-dividend date: The cut-off date to have dividends paid for the current payment period. Stocks purchased after this date will receive a payment in the following payment period.
• Record date: The date you as a shareholder must be recorded in the company’s recorders to be eligible to receive a dividend.
• Declaration date (or announcement date): The date a company’s board of directors announces the next dividend payment as well as any changes to the ex-dividend date.

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Types of Dividends

Depending on your goals and preferences, there are a few different types of dividend-paying stocks you can choose from. Consider these options when deciding which types of dividend stocks you might be interested in purchasing.

Cash dividends: These are cash payments made straight to an investor, usually deposited into your brokerage account. If you choose to, you can reinvest your cash dividends back into the company’s stock to grow your portfolio.

Stock dividends: Rather than paying cash, some companies increase the number of shares an investor owns as a dividend payment.

Special dividends: Instead of regular payments, special dividends are one-off distributions, usually tied to an event like the sale of an asset or a liquidation.

Preferred dividends: Stocks can be offered in different classes, with preferred stock having higher priority over regular common stock. Dividends earned on preferred stocks are usually paid out ahead of common stockholders.

Property dividends: Occasionally, companies pay investors with property rather than cash or equity. This is a non-monetary dividend that has value but it isn’t liquid. It can include things like physical property or products.

How Are Dividends Paid?

Dividends are usually paid out every quarter but some dividends pay out every month or twice a year. REITs are one of the most popular types of stocks that pay monthly. The date of a payout is determined by the board of directors. They’ll announce the dividend, the ex-dividend date, and when investors should expect to receive their payment.

These are paid from a company’s profit and are usually deposited directly into a shareholder's brokerage account as a cash payment. However, if they participate in a reinvestment program, it will be reinvested in a company’s stock instead.

While can be a great way to generate recurring income, they aren’t guaranteed. If something happens, the board of directors can decide to halt dividend payments. For example, Unilever, a multinational consumer packaged goods company, cut its dividend following the 2008 Global Financial Crisis. Its dividend has still not recovered to pre-crisis levels.

How Are Dividends Taxed?

Dividend payments are a form of unearned income, which means they are taxed like income. The rate at which they are taxed depends on whether or not the dividend is considered qualified. 

It is considered non-qualified if you purchased a stock 60 days or less than the stock’s ex-dividend date. If you’ve had a stock for more than 60 days following the ex-dividend date, then it’s considered qualified.

Non-qualified ones are taxed as regular income, while qualified ones are taxed as capital gains. The current capital gains tax rate is 0%, 15%, or 20% depending on your taxable income. Considering the federal income tax rate ranges from 12% to 35%, one that is considered a qualified dividend can save you on taxes.

There are some exceptions to how dividends are taxed. If a dividend-paying stock is purchased in a tax-advantaged retirement account, like a Roth IRA, any dividends earned aren’t taxed (unless you make an early withdrawal).

Related: Understanding passive income vs earned income

FAQs

How do you find dividend stocks? 

Information about whether or not a stock is a dividend-paying stock can be found on the Security and Exchange Commission’s website or financial media outlets like The Wall Street Journal. More information can also be found by searching through stock profiles in a brokerage account.

How do you make money from dividends?

The easiest way to make money from these is to hold a dividend-paying stock and collect a regular cash payout when they are issued. To increase the amount of income you can earn, you can opt to reinvest them instead.

Another strategy you can use is to take the cash you earn from dividends to purchase other assets, like real estate. Using dividends as a source of cash flow, you can use these earnings to finance other income-generating projects.

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