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How Do Dividends Work?

February 26, 2020 · 5 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

How Do Dividends Work?

Congratulations! You’ve invested in a company that may be kicking the world’s butt. Your reward? A little slice of the leftover pie in the form of a dividend. Put into a more financial definition, a dividend is often a share of a company’s profit paid out to shareholders.

Seasoned investors might be able to figure out how to live off these dividends, with regular checks coming their way. If that’s a goal for you, you may want to get schooled on every aspect of investing in stocks that could shower you with dividends.

It might not be as easy as it sounds, of course, but a little education could go a long way. This article might help with the very basics.

What Are Dividends?

Think of a dividend as a small reward for investing your money in a company’s stock. That’s the company’s way of saying “thank you” for believing in them and allowing you to share in their wealth after what may have been a good performance. This dividend can come in the form of cash or even more stock.

A single dividend on its own may not seem like it’s worth much. The real power lies in the dividends compounding.

Regular cash dividends are paid out of the company’s profits. They’re paid to the owners of the business (namely, you).

Why Would a Company Pay Dividends?

The answer can be pretty complex. First, companies can leverage their profits in one of three ways—reinvesting in the company, buying back shares of stock, or paying dividends to shareholders.

A company could simply view dividends as a more efficient use of their profits than the other two options. Second, companies may pay dividends to meet the expectations of shareholders and the industry.

A historical precedent of paying dividends or being in an industry in which peers pay dividends could influence the behavior of the company. The bottom line is that there are many reasons a company would pay dividends, which is why you might want to do your homework and make sure you are investing in a company for the right reasons.

Why Would a Company Not Pay Dividends?

You may be more likely to receive a dividend from older companies that is more established and have a history behind them. New companies are more likely to wait to pay dividends until they are more mature.

In other words, they may not have a profit or may have a different strategic use of their profit. They might need that extra money to reinvest into the company so that it can grow.

Often, a more established company may pay higher dividends because they may not have strategic opportunities to reinvest as much in the business and it’s more efficient to give profits back to the owners (you!).

Sometimes, investors see the lack of dividends—or the decision not to award dividends—as a red flag. It could mean that the company is not doing well financially or that earnings are not up to standards (this may not necessarily be the actual reason—you might have to do some research).

As a result, some investors might stay away from stocks that do not pay regular dividends.

As referenced above, there can be as many reasons companies don’t pay dividends as they do pay dividends. You might want to do your homework either way to be sure you are investing for the right reasons.

How Are Dividends Paid?

In the United States, most dividends are paid in cash, according to U.S. New & World Report. In that scenario, a certain amount of cash would be equal to the stock share’s worth.

For example, if a company pays you a dividend of 20 cents per share, you would receive $20 in cash if you owned 100 shares. If the company pays dividends in stock rather than cash, you receive additional shares once the additional stock is distributed to you—and you didn’t have to do anything but believe in the company and stick with it.

Are Dividends Always Taxable?

All dividends need to be reported on tax returns, and some will require paying taxes on them. Dividend payments can either be classified as qualified or non-qualified, with qualified dividends being taxed at an individual’s capital gain rate.

Non-qualified dividends are taxed at an investor’s ordinary income rate, which could be higher. It can get complicated, so you might want to talk to a tax professional about it.

Are All Stocks and Dividends Alike?

The most common type of stock is, well, common stock. Common stocks are what most investors have. You own a small piece of the company without having to run or operate the company.

Sometimes, you’ll be able to vote on all kinds of corporate decisions, including who can sit on the Board of Directors, and you’ll get a copy of the company’s annual report.

Voting rights can vary by company: With some, you get one vote per share you hold, while with others, you get a single vote per shareholder, no matter how many shares you own.

Preferred stock is another type of stock: The investors who own preferred stock do not get voting rights but they do get higher dividends than common stock investors. Preferred stock investors also receive their dividends before common stock investors.

There are property dividends too, but they’re not quite the same thing. Property dividends are actual property, like furniture, gold, silver, or perhaps a product the company manufactures.

Are Dividends a Sure Thing?

Nope. Companies may increase their dividends for a number of reasons,because they are performing well or simply because there is not a more strategic use of their profits. Companies may decrease their dividend because they are underperforming or because there is a more strategic use of their profits.

The bottom line is that dividends are not guaranteed. The company’s board of directors decides whether a dividend is going to be paid to the investors. In fact, this board can choose how much to pay our or pay fewer dividends or even forgo them.

If you’re a young investor, reinvesting those dividends could do you a solid. Rather than cashing in your chips every time a dividend is paid, you could reinvest the dividend in that stock and sit back and let those babies compound.

What If the Stock Value Falls?

If the value of a stock falls, you might still win big. You could reinvest dividends in that lower-priced stock and get more shares per eventual dividend. In addition, the dividends could still provide some sweet income if needed, even if the price falls and dividends are still being paid.

A falling stock price does not always indicate a buying opportunity and does not always indicate that you should sell. You might want to take a holistic view and decide if you believe in the long-term future of the company. If so, reinvesting dividends in stock that is priced lower could be beneficial.

If your stock price falls, don’t let it get you down. From 1930 to 2012, nearly 42% of the total returns on the S&P 500 have been from dividends.

What’s the Best Way to Invest in Dividend-Producing Stocks?

Mutual funds and exchange-traded funds (ETFs) might be a good way to go, especially if you are a beginning investor. ETFs contain different types of investments, and your money is spread out (diversified) among them. This allows you to get more diversified with smaller amounts of money.

Diversification is a specific mix of assets that will help you spread your investments among many companies rather than a few. Investing in multiple companies could reduce volatility over the long term because you lower the risk associated with a given company.

With an ETF, if one company’s stock doesn’t do so well, you won’t lose all your money, because your investment was spread among many companies.

How You Can Get Started on Dividend Investment

You could get started investing today by opening an account with SoFi Invest®. SoFi Invest offers an active investing solution that allows you to choose your stocks and ETFs without paying SoFi fees and commissions. SoFi Invest also offers an automated investing solution that invests your money for you based on your goals and risk, without charging a management fee.

Get started with SoFi Invest today!

External Websites: The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
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