Some companies share part of their profits directly with shareholders through payments called dividends. For many investors, dividends are an important source of income and a significant contributor to long-term returns. Here’s how dividends work and what to know about dividend-paying stocks and funds.
What dividends are
A dividend is a payment from a company to its shareholders, usually representing a portion of the company’s profits. Dividends are most often paid in cash, typically on a quarterly basis in the United States, though some companies pay monthly, semiannually or annually. Some companies also pay special one-time dividends or dividends in the form of additional shares of stock.
If you own shares of a company that pays a dividend, you receive a payment based on the number of shares you own. For example, if a company pays a quarterly dividend of 50 cents per share and you own 100 shares, you would receive $50 that quarter.
Mutual funds and exchange-traded funds that hold dividend-paying stocks collect those dividends and pass them along to fund shareholders, usually on a regular schedule.
Which companies pay dividends
Mature, established companies with stable profits are more likely to pay dividends. These companies often operate in industries like utilities, consumer staples, health care, financials and energy, where steady cash flow allows them to return money to shareholders.
Fast-growing companies often pay little or no dividend, instead reinvesting profits back into the business to fund expansion, research and development or acquisitions. Investors in these companies hope to benefit from rising stock prices rather than dividend income.
A company’s board of directors decides whether to pay a dividend and how much. Dividends aren’t guaranteed. Boards can increase, reduce or eliminate dividends at any time, often in response to changes in profits or business conditions. During economic downturns, some companies cut or suspend their dividends.
Key dividend terms
Dividend yield is the yearly dividend per share divided by the stock’s price, expressed as a percentage. If a stock priced at $100 pays $3 in annual dividends, its dividend yield is 3%. Yield changes as the stock price moves.
The ex-dividend date is an important date to know. You generally need to own the stock before the ex-dividend date to receive the next dividend. If you buy on or after the ex-dividend date, the previous owner receives the dividend instead.
The payout ratio is the share of a company’s earnings paid out as dividends. A very high payout ratio might suggest the dividend could be difficult to sustain if earnings decline.
The record date and payment date are also part of the process. The record date is when the company determines which shareholders are eligible, and the payment date is when the dividend is actually paid.
Reinvesting dividends
Many brokers let you automatically reinvest dividends to buy more shares of the same stock or fund, often called a dividend reinvestment plan, or DRIP. Reinvesting means your dividends buy additional shares, which then generate their own dividends.
Over time, reinvested dividends can significantly boost total returns through compounding. Historically, reinvested dividends have accounted for a substantial portion of the stock market’s total long-term returns.
Investors who need income, such as retirees, may choose to receive dividends as cash instead.
How dividends are taxed
In taxable accounts, dividends are generally taxable in the year you receive them, even if they’re automatically reinvested. Dividends are classified as either qualified or ordinary.
Qualified dividends, which generally come from U.S. companies and certain foreign companies when you meet holding period requirements, are taxed at lower long-term capital gains rates. Ordinary, or nonqualified, dividends are taxed at your regular income tax rate. Your broker reports dividends on Form 1099-DIV each year.
Dividends earned in tax-advantaged accounts, such as IRAs and 401(k)s, aren’t taxed when received. Check irs.gov for the current rules.
Don’t chase high yields
An unusually high dividend yield can be a warning sign rather than an opportunity. Sometimes a yield looks high because the stock price has fallen sharply, often due to problems at the company. If the company’s troubles continue, it may cut its dividend, and the stock price may fall further. This situation is sometimes called a yield trap.
When evaluating dividend stocks, consider the company’s overall financial health, earnings stability, debt levels, payout ratio and history of maintaining or growing its dividend, not just the size of the payout.
Dividend investing in a diversified portfolio
Dividend-paying stocks can be part of a diversified portfolio, but focusing exclusively on dividends can concentrate your investments in certain industries and miss growth from companies that don’t pay dividends. A total return approach, which considers both dividends and price growth, is how many investors evaluate performance. Broad index funds include both dividend-paying and growth-oriented companies, giving you exposure to both.
This article is for education only and isn’t investment advice.
Content on The Evergreen Edit is for educational and informational purposes only and is not individualized financial, investment, tax or legal advice. Learn more.
This article is for educational purposes only and isn't personalized financial, tax or legal advice. Consider talking with a qualified professional about your situation.
Kiara Miller — Founder & Editor
Kiara Miller is the founder and editor of The Evergreen Edit. He has been doing independent finance research for two decades and reviews every article before it's published.
More about Kiara →Get smarter about your money.
Join readers who get The Sunday Edit every week.
