Ever heard the saying, “It pays dividends.” Nine times out of 10 that means you’ve probably just been given a nudge to do something now that might pay off later. But what are dividends? And how do dividends work?
In the world of stocks, dividends are regular payments of a company’s profits to shareholders. They’re like a reward for putting your money into their venture. See? You invest with us now, and we’ll give you something—a dividend—later. Bottomline is a dividend is a form of payment!
Companies typically pay out dividends in cash. But there are other types of dividends you could receive, including stock dividends and opportunities to do some dividend investing. We'll get to all that in a minute. But first, let’s take a look at how dividends work.
How Do Dividends Work?
Dividends are like the cherry on top for investors—a little something extra to sweeten the deal. But why do companies shell out dividends? What’s the motivation?
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For starters, it’s a way of rewarding investors for putting their trust—and more importantly, their cash—in the company. Dividends also tend to have a positive effect on an investor’s outlook on the company. If you’re consistently getting paid good dividends, you’re probably going to be a pretty loyal investor! Let’s look at a basic example.
Say you buy 10 shares in the Acme, Inc. company. At the end of the quarter, they announce a $1 dividend per share, so you get a $10 dividend payment. If Acme, Inc. does this each quarter for a year, you’ll end up with a total dividend of $40. Those funds are usually paid straight into your brokerage account. Pretty simple, right?
But not all stocks pay dividends. And not all dividend stocks are paid in cash. The company’s board of directors makes the call on how the company pays its dividends and how frequently they’re paid out—monthly, quarterly (most common in the U.S.) or annually. The catch is that the board also has to get shareholder approval on the distribution of the dividends through a vote. That means the same people potentially receiving dividends are the same people voting on how they are given out.
Let’s take a look at other types of dividends you can earn.
Types of Dividends
There are five main types of dividends you’re likely to encounter when investing:
- Cash dividends. They’re exactly what they sound like: cash paid out to you on your investment.
- Stock dividends. This one’s also pretty self-explanatory. Instead of cash, you’re given additional shares of stock. Now you own a little more of the company than you did before.
- DRIPs. This terrible acronym stands for dividend reinvestment programs. DRIPs let you reinvest your cash dividend back into the company’s stock—often at a discount.
- Special dividends. This kind of dividend is a wild card. A company can give out special dividends if they’re sitting on extra profits they don’t have earmarked for something else. These types of dividends are more one-offs and don’t arrive on a schedule like other dividends.
- Preferred dividends. This is another unique type of dividend. A preferred dividend is paid to owners of preferred stock. This type of stock differs from common stock in that with preferred stock, shareholders don’t have any voting rights. Preferred dividends will follow a payout schedule similar to cash or stock dividends, but they’re usually a fixed amount rather than a fluctuating number.
On top of getting bonus money, a lot of folks like dividends because they can come with some tax advantages.
What Are Qualified Stock Dividends?
Before you can cash in on any tax advantages, you need to know if you have qualified stock dividends or unqualified stock dividends. Here’s the difference:
- Qualified: Basically, you need to own the stock for a while before it’s considered qualified. In technical—and pretty confusing!—terms: You need to own the stock for more than 60 days before the ex-dividend date (or ex-date)—aka the day that determines your eligibility to receive the dividend. The dividend also has to be paid by a U.S. company or qualified foreign corporation. Qualified dividends get better tax rates because they’re actually taxed at long-term capital gain rates rather than income tax rates.1
- Unqualified: Also known as ordinary dividends, these dividends are unqualified because you didn’t own the stock for more than 60 days before the ex-date. These dividends are taxed at your regular income tax rate.
Alternative Dividend Sources
Now, dividends don’t only come from single stocks. Other investments, and even some insurance companies, also pay dividends. For example, mutual funds contain shares of multiple companies’ stocks, so you’re considered a shareholder and can receive dividends.
In the case of mutual funds, the dividend is based on a fund’s net asset value (NAV) calculation (that’s just a fancy way to say assets minus debts) when the stock market closes. If your shares in the fund earned a profit, the mutual fund company can choose to use that money to reinvest in the company, pay down debt, or give you a cut of the profit in the form of a dividend.
Bonds are another type of investment that can pay dividends. As a refresher—when you buy a bond, you’re lending money to a company or government entity. In exchange for your loan, the company or government agrees to pay you a fixed rate of interest, aka a dividend. Unlike stock dividends, bond dividends are a legal obligation, meaning the company or the government entity you loaned money to has to pay you dividends. We don’t recommend hinging your investment strategy on bonds though. You’re better off investing your money in a mix of growth stock mutual funds.
This final dividend provider may surprise you—it’s life insurance. Some insurance companies are called mutual insurance companies. That means they’re not publicly traded and the policyholders—you and others—own the company “mutually.” If the company makes a profit, they can declare a policyholder dividend. But remember, people: Life insurance is not an investment—it’s insurance. So, skip the gimmicks here and go for a solid term life insurance plan.
How Do Dividends Affect Stock Prices?
Have you ever seen the running of the bulls? Well, it looks a lot like that once news of a dividend payment becomes public. You’ll see a rush to purchase the stock before the ex-date. When that happens, you’ll see the share price go up. You’ll also notice the price dropping after the ex-date. Anyone buying the stock on or after that date won’t receive the dividend, so people sell the stock.
Is Investing Just for the Dividends a Good Idea?
While dividends might feel like a bonus or reward, it doesn’t make sense to invest in something just for the dividends.
When you get to the point where you’re investing 15% of your income so you can retire inspired, stick with employer-sponsored plans, like 401(k)s or 403(b), and Roth IRAs with good growth stock mutual funds. And, hey, some of those mutual funds might pay dividends, so you may still get a bonus after all!
Get With a SmartVestor Pro
Look, there’s a lot to take in when you’re trying to figure out what makes an investment worthwhile, but you can do this. And you don’t have to do it alone. Connect with an investment professional, like one of our SmartVestor Pros, who can walk you through your best options. Our program connects folks with qualified investment professionals who are familiar with what we recommend and can guide you in creating a retirement plan with your goals in mind.