What Are Dividends?

A dividend is a payment that some companies distribute to their shareholders. Paying shareholders a portion of earnings helps attract investors seeking income-producing investments or who want to invest in a business with strong financials.

How Dividends Work

A company’s board of directors decides when to pay dividends. The process requires setting deadlines and sharing information, including the following milestones:

• Declaration date: The date a company announces the main information about a dividend.

• Record date: The date on which a company decides which shareholders are entitled to receive a dividend.

• Ex-dividend date: The date before which an investor must hold shares to be entitled to the dividend payment.

• Payment date: The date on which the dividend is distributed to shareholders.

Dividend-paying companies tend to be larger, firmly established businesses. When a business pays dividends, it has less to reinvest in itself. As a result, companies typically pay dividends as their growth rates decline.

Types of Dividends

The type of dividend affects the payment frequency and taxation:

• Regular dividends: Paid on a consistent schedule, typically quarterly, although monthly or annual payouts are possible.

• Special dividends: A one-time payment typically tied to a particular event or higher-than-expected earnings, or issued by a company that does not pay regular dividends.  

• Preferred dividends: Fixed amounts paid to owners of preferred stock, offering predictable income and low volatility.

How Dividends Are Paid

Dividends can be paid in stock or cash:

• Shareholders enrolled in a dividend reinvestment plan (DRIP) have their dividends purchase additional or fractional shares of company stock.

• Shareholders who prefer cash payments can have a payment mailed as a check or directly deposited into a designated account, such as a brokerage account.

• Dividends in a brokerage account can be withdrawn, reinvested in the company, or invested in a new asset.

How Dividends Are Taxed

Dividends held in brokerage accounts are taxed. Conversely, dividends in tax-advantaged accounts, such as retirement accounts, are not taxed.

When dividends are taxed, they are considered ordinary or qualified:

• An ordinary dividend is taxed at the shareholder’s ordinary income tax rate.

• A qualified dividend is taxed at the shareholder’s capital gains tax rate, which is typically lower than their ordinary income tax rate.

• Depending on a shareholder’s income, the capital gains tax rate at the federal level is 0%, 15%, or 20%.

For a dividend to be qualified, an investor must hold shares for the following periods of time before receiving the payment without hedging the investment:

• Common shares: At least 61 days within 121 days, starting 60 days before the ex-dividend date.

• Preferred shares: At least 91 days within 181 days, starting 90 days before the ex-dividend date.

• Mutual funds: The fund must meet either of the above requirements for the specific underlying security, and the shareholder must have held their applicable share(s) of the fund for at least 61 days within 121 days, starting 60 days before the fund’s ex-dividend date.

Tips to Evaluate Dividend-Paying Stocks

Consider the following when deciding whether to invest in dividend stock:

Dividend Yield

The dividend yield is an estimate of the annual return a shareholder might earn from the dividend, assuming the stock continues to pay its dividend. 

Dividend History

Determine whether the company has a track record of paying dividends regularly, sporadically, or never. Whereas a long history of consistent dividend payments implies financial stability, pausing or cutting the dividend program could indicate financial challenges.

Dividend Growth Rate

Learn how the company’s dividend yield changed over time, in both the short and long term. Focus on whether any growth kept pace with inflation.

Dividend Payout Ratio

Focus on how much of a company’s earnings it pays to shareholders:

• Whereas less-established companies might prioritize reinvesting cash to grow, more-established companies could be less focused on growth.

• Typically, the lower the dividend payout ratio, the more sustainable a company’s dividend might be.

• Learn whether the dividend is well-covered by the earnings, or the payouts seem unsustainable.

Non-Dividend-Related Factors

Other elements to consider when making an investment decision include:

• The company’s financial health

• Industry trends

• Economic trends

Consider your personal situation, including:

• Financial goals

• Time horizon

• Risk tolerance

What You Can Do with Dividends

Your investment goals impact what you do with dividends. For instance, if you want to generate income without selling your stocks, you can put some or all of your dividend payments toward expenses. Conversely, if you are investing for long-term growth, you might reinvest the dividends in the same company’s stock or purchase shares of a different company or asset class for diversification.

*This information is for educational purposes only.

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