How Do Dividends Work?

March 16, 2021 · 5 minute read

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How Do Dividends Work?

Dividends are payments to stockholders that some companies make as a way of sharing their profits. They are one of the ways that investors can make money from stocks and build long-term wealth.

Dividends are usually cash payments that are paid on a regular basis. Investors can draw on these payments as income or reinvest them in the stock market. Here’s a closer look at how dividends work and how investors can take advantage of them.

What Are Dividends?

Dividends are shares in a company’s profits that are paid to stockholders in cash, and in some rare instances stock. They represent one of the most common ways investors can make money from stock aside from selling appreciated stock.

Dividends can generally be divided into two broad categories: regular and special dividends.

Regular Dividends

Regular dividends are those which the company expects to pay out on a recurring basis. Typically, a company will set regular dividends at a value they expect to be able to pay, even when times are tough.

Special Dividends

Special dividends are usually one-time payments that follow special circumstances. For example, if a company sells an asset and has no immediate need for the proceeds, they may use them to fund a special dividend.

Why Do Companies Pay Dividends?

When a company starts to earn more than it needs to cover operating expenses (one of many line items in a profit and loss statement) and reinvest in its own business, it may start paying out dividends. Typically, companies in this situation are mature and well-established, requiring little reinvestment of capital to grow.

Offering dividends can be a smart move on the company’s part. They can signal that the business is robust and financially healthy, drawing the attention of investors looking for income, which in turn may potentially drive up share prices.

How Do Dividends Get Paid Out?

Dividends are usually paid out quarterly—though some pay out monthly. They are paid on a per-share basis, typically in cash. So, for example, if a company is paying a dividend of $0.15 per share and you own 100 shares, you’ll receive $15.

Stock dividends are issued as a percentage of the shares you own. So if you receive a 5% stock dividend and you own 100 shares, you’ll receive five shares for a total of 105 shares.

Companies that pay dividends usually declare them a number of weeks before paying them out, when the board of directors makes an official announcement that a dividend will be paid. When it come to dividend payment, there are a number of important dates to be aware of:

Declaration date: The day the board of directors makes its official announcement that it has decided to make a future dividend payment.
Payment date: The date on which dividend payments are made to shareholders—either with a check in the mail or through money transferred to your brokerage account.
Record date: The date by which you must be an owner of the dividend-paying company’s stock in order to receive the declared dividend.
Ex-dividend date: The ex-dividend date is usually the day before the record date. On this day, stocks are trading without the dividend. In order to receive a declared dividend, you must have bought stock the day before the ex-dividend date, and you must be an official owner of the stock by the record date. Investors who purchase the stock on or after the ex-dividend date will not receive the upcoming dividend. Rather they will have to wait until the next dividend payment is announced.

Are Dividends Guaranteed?

Some investors like to structure their investments so that they can live off dividend income. However, it’s important to note that though dividend payments are usually paid on a regular basis, they are not guaranteed.

Rather they are paid at the discretion of the company board of directors, which can change the amount of the payment or cancel it altogether. If a company decides to cut dividends, there is a hierarchy of payment they will usually consider. They will typically pay bondholders first, followed by preferred stockholders. Common stockholders are paid last.

Which Companies Pay Dividends?

Generally speaking, large, mature companies that are not currently focused on fast growth offer dividends. For example, most companies in the S&P 500 Index, which represents the 500 largest U.S. companies by market capitalization, pay dividends.

Younger, fast-growing companies are unlikely to offer dividends. Instead they tend to focus on reinvesting earnings to grow their business, open more stores, build new facilities, or hire more employees.

How to Choose Dividend Stocks

When considering which dividend stocks to buy, investors may want to look at dividend yield, which measures how much income they will receive for every dollar invested in the stock. The higher the yield, the more income they can expect.

Investors may also want to consider the dividend payout ratio, the portion of a company’s income that goes toward paying dividends. As a rule of thumb, investors might want to look for a payout ratio of 80% or less. Any higher and the company may be in danger of being unable to make its dividend payments.

How Do Dividends Affect Stock Prices?

In the short-term, dividends can drive down the price of a stock a little bit. That’s because investors who buy the stock on or after the ex-dividend date don’t get to benefit from the upcoming round of dividends. So they may be reluctant to pay a premium for a reward in which they don’t get to take part. In fact, some specialists may mark down the price of a stock by the amount of the dividend on the ex-dividend date.

Stock prices may also fall when a company announces a reduction in their dividend, which could signal that they expect weak sales or lower profits due to other facts like higher operating costs. If investors think a company is headed for hard times, they may be tempted to sell, which would drive down the stock’s price.

On the flip side of that coin, when a company offers a higher dividend or a special dividend, investors may see it as a harbinger of financial health, which can make the stock more attractive to investors and drive up the price.

How Are Dividends Taxed?

If you receive dividends in a taxable brokerage account, they are considered taxable income and will be taxed at your regular income tax rate or as long-term capital gains. Dividends that are paid inside tax-advantaged savings accounts—such as traditional and Roth IRAs, 401(k)s, and Coverdell ESAs —are not taxed.

A dividend is eligible for the lower capital gains rate if it is a “qualified dividend.” To meet this standard, a dividend must me the following criteria:

•  It must be paid by a U.S. corporation or qualified foreign corporation.
•  It must be an ordinary dividend and not capital gains distributions or dividends from tax-exempt organizations.
•  You must have held the stock for more than 60 days in the 121-day period that begins 60 days before the ex-dividend date.

The Takeaway

Investing in stocks that offer dividends can be a good strategy for investors looking for income and to build their wealth potentially faster than with non-dividend stocks. The reasoning: Investors who reinvest their dividends can buy additional shares of stock, which in turn entitles them to more dividends in the future.

If you’re ready to add dividend-paying stocks to your portfolio, check out SoFi Invest®. The Active Investing platform lets investors choose from an array of stocks, ETFs or fractional shares. For a limited time, opening an account gives you the opportunity to win up to $1,000 in the stock of your choice. All you have to do is sign up, play the claw game, and find out how much you won.

Find out how to get started with SoFi Invest.

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