A dividend is a fancy accounting term that technically means profits. When companies distribute profits, they have said to have distributed dividends.
Not every company pays dividends, but the ones that do are some of the biggest companies in the world like Apple, Microsoft, Intel, Disney, JP Morgan, etc.
I am a dividend growth investor and intimately familiar with dividends. I only invest in dividend-paying stocks and believe it’s one of the best ways to compound wealth.
What are Dividends?
When companies distribute their profits to shareholders, it’s called a dividend distribution. Each share of stock in the company entitles you to a dividend payment. Let’s say Company A pays 10 cents dividend per share. For every share you own in the company, let’s say you own 10 shares, you will get 10 cents in dividend adding up to $1.
Dividends are paid in cash or additional stock. Majority of the time, its a cash payment.
What is a Stock Dividend?
Instead of cash payment, you get additional stock. Upon receiving the additional stock, you can sell it for cash or keep it.
What is a Preferred Stock Dividend?
Shareholders who purchase preferred stock, get paid preferred dividends. When the company is in financial difficulty, the preferred stockholders receive their dividends before the common stockholders.
What is a Common Stock Dividend?
Everyone else that doesn’t own preferred stock is considered a common stockholder. During liquidation, common stockholders are last in line to receive a dividend promised when acquiring the stock.
When are Dividends paid?
Companies pay dividends monthly, quarterly, or yearly. There are three key dates to remember when it comes to the dividend payments: the declaration date, the ex-dividend date, and the payment date.
- Declaration date. The date on which the company’s board announces a dividend will be paid. The board votes on the dividend payment amount.
- Ex-dividend date. In order to receive the dividend, you must own the stock before the ex-dividend date. Typically, this date is one day before the company checks its list of shareholders to identify who gets the dividend. If you buy shares on or after the ex-dividend date, you won’t receive the related dividend payment. That said, if you sell your shares on or after the ex-dividend date, you will still receive the dividend payment.
- Payment date. It’s self-explanatory, the day shareholders get their dividend.
In short, as long as you own the stock on or before its ex-dividend date, you will get your dividend.
Dividends and ETFs
ETFs are just index funds that mimic a specific exchange, most commonly, the S&P. These ETFs own dividend stock. In the case of dividend distribution, you will receive your portion based on the number of shares you hold of the given ETF.
Dividends and REITs
Real estate investment trusts or REITs own and operate income-producing real estate. REITs are required to distribute 90% of their taxable income in the form of dividends.
For that reason, REITs receive special tax treatment. As in, they pay no corporate taxes on their earnings they payout.
What is a Dividend Yield?
The dividend yield, denoted as a percentage, is a ratio that shows how much a company pays out in dividends each year relative to its stock price.
The dividend yield is calculated using the following formula:
Dividend Yield = Dividend / Stock Price
Company A trades at $20 and pays an annual dividend of $1 per share. The dividend yield, in this case, will be $1/$20 = 5%.
Please note that the dividend yield for extremely active companies can change almost daily because of the change in the stock price.
How are Dividends taxed?
There are two kinds of dividends as far as the tax code goes. Qualified dividends and ordinary dividends. So the taxation of dividends depends on the nature of the dividend.
- Qualified dividends
If you receive a dividend from a U.S. or a foreign company that’s listed on the major stock exchange, chances are, that’s a qualified dividend. Qualified dividends are listed in box 1b on IRS Form 1099-DIV, the tax form sent to shareholders receiving dividends during the year. Based on your income and filing status, dividends are taxed at 0%, 15%, and 20% tax rate.
- Ordinary dividends
If you receive a dividend from a REIT, MLP, etc., it is considered an ordinary dividend. Based on your income and filing status, it is taxed at standard federal income tax rates, between 10% – 37%, for the tax year 2020.
What is a Dividend Reinvestment Plan or DRIP?
A dividend reinvestment plan or DRIP lets you reinvest the cash dividends into buying an additional stock of the same company. If you don’t enroll in DRIP, your dividend will be deposited into your brokerage account.
Let’s say you buy 100 shares at $50/share with an annual dividend of $1. After 10 years, this is how your returns would look like with and without dividend reinvestment.
With dividend reinvestment, you compound the dividends by buying more shares which in turn gives you more dividends. This kind of compounding is why dividends accounted for 42% of the total return of the S&P 500 from 1930 to 2019, according to an analysis by Hartford Funds.
That’s it, you now know more about dividends than you did 4 minutes ago. I hope this post was informative and provided value.
If you want to know about anything else related to dividends, please feel free to comment below or connect with me on Twitter.