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What Are Dividends and How Do They Work?

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?

Dividends are payments companies make to their stockholders to share their profits. Typically paid quarterly, dividends are like a reward for investing your money into a company’s venture. See? You invest with us now, and we’ll give you something—a dividend—later.

Companies usually 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 Are Dividends Paid?

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?

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 of Acme Inc. and Acme has a strong quarter selling widgets. At the end of the quarter, Acme announces a $1 dividend per share, so you get a $10 dividend payment. If Acme 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. Some companies decide to reinvest their profits in their company rather than paying dividends. The company’s board of directors makes the call on how the company pays its dividends, how much to pay 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 through a vote on the distribution of the dividends. That means the same people potentially receiving dividends are the same people voting on how they’re given out.

Let’s take a look at all the 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.

How Can I Find Out if a Stock Pays Dividends?

It’s up to each individual company to decide if it will pay dividends. Generally speaking, well-established companies with long histories of growth and earnings are more likely to pay dividends. Start-up or new companies are usually so focused on growth that they choose to reinvest their profits in the company rather than paying dividends.

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It’s pretty easy to find out if a stock pays dividends. Just search a company name on a stock quote website, and boom, you’ve got a list of data including the stock’s current price, dividend per share and dividend yield. While some stocks pay higher dividends, more often than not, the dividend per share is less than $1. Still, that can add up if you own a lot of shares, and remember, dividends are paid quarterly.

Dividend yield is a little more complicated. We’ll spare you the formulas, but yield measures the value of the dividend compared to stock price. Let’s go back to our Acme Inc. example. If Acme’s share price is $100 and it pays out $4 in dividends per year, its yield is 4/100 or 4%. By the way, that’s a pretty good yield. (The average dividend yield for the S&P 500 is a little over 1%.)1

Companies that have a history of paying dividends usually continue to pay them. But a word of warning here: Companies and their stockholders can decide to increase, decrease or stop dividends depending on the company’s profitability.

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 nonqualified stock dividends. Here’s the difference:

  • Qualified: Qualified dividends get better tax rates because they’re taxed at long-term capital gains rates, which are lower than normal income tax rates.2 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, which is the deadline to buy a stock and receive the dividend. If a buyer purchases stock after the ex-date, the dividend goes to the seller.
  • Nonqualified: Also known as ordinary dividends, these dividends are taxed at your regular income tax rate because you didn’t own the stock for more than 60 days before the ex-date.

Do Mutual Funds Pay Dividends?

Now, dividends don’t only come from single stocks. Other investments, and even some insurance companies, also pay dividends. Mutual funds that hold stock in companies that pay dividends can pass along those dividends to shareholders who have the option of getting a payout (typically once a year) or having dividends reinvested in additional shares of the fund.

At this point you’re probably wondering: Why haven’t I received a dividend check from the mutual funds in my retirement account? This is because retirement accounts require shareholders to reinvest any dividends paid by the fund. So if you look really closely at your retirement account statement—yeah, we’re guilty of just looking at the big number at the top too—you’ll probably find a line item for dividends.

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.

How Do Dividends Affect Stock Prices?

Have you ever seen the running of the bulls in Spain? 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 (the deadline to buy stock and receive the dividend). When that happens, you’ll see the share price go up. You’ll also notice the price dropping after the ex-date because 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 Roth IRAs and employer-sponsored plans like 401(k)s with good growth stock mutual funds.

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 investment professionals who are familiar with what we recommend and can guide you in creating a retirement plan with your goals in mind.

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This article provides general guidelines about investing topics. Your situation may be unique. To discuss a plan for your situation, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros. 

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