What Is a Dividend and How Do They Work?

What Is a Dividend?

A dividend is a portion of a company’s profits that it distributes to shareholders. Dividends are paid out in addition to any gains in the value of the company’s shares and reward shareholders for holding a stock.

Companies in certain sectors are known for paying dividends, and dividends are more common among established companies that can afford not to invest all of their profits back into the business. Companies might pay special, one-time dividends, or they may pay dividends at regular intervals, such as every quarter or once a year.

One of the big advantages of preferred stock is that it dependably pays regular dividends, although common stock may also pay out regular dividends. Unlike bond interest payments, however, dividend payments are not guaranteed. Companies may cut or even eliminate dividends when they experience hard economic times.

Basic Risks of Dividend Investing

  • Share prices can drop. This situation is possible regardless of whether the company pays dividends. Worst-case scenario is that the company goes belly up before you have the chance to sell your shares.

  • Companies can trim or slash dividend payments at any time. Companies are not legally required to pay dividends or increase the payments they make. Unlike bonds, where a failure to pay interest can put a company into default, a company can cut or eliminate a dividend whenever it wants. If you’re counting on a stock to pay dividends, you may view a dividend cut or elimination as losing money.

  • Inflation can nibble away at your savings. Not investing your money or investing in something that doesn’t keep pace with inflation causes your investment capital to lose purchase power. With inflation at work, every dollar you scrimped and saved is worth less (but not worthless).

Potential risk is proportional to potential return. Locking your money up in an FDIC-insured bank that pays an interest rate higher than the rate of inflation is safe (at least the first $100,000 that the FDIC insures), but it’s not going to make you rich.

On the other hand, taking a gamble on a high-growth company can earn you handsome returns in a short period of time, but it’s also a high-risk venture.

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The Bonus Benefits of Dividend Investing

1. Capital Appreciation

I’m going to be discussing mostly dividend income in this guide, but dividend stocks also have the potential to generate capital appreciation. After all, they’re stocks, and they do tend to rise in value over the long term.

Let’s take Pepsi (PEP) as an example. The stock is currently paying a dividend of nearly 3% per year. The current share price is about $143. But you could have purchased the stock 10 years earlier at less than $65 per share. That means the value of the stock more than doubled in 10 years—all while earning 3% per year for you in completely passive income.

That indicates the double-edged advantage of dividend stocks—not only do they provide steady income, but they also provide capital appreciation. That protects your investment against inflation but also enables it to grow over the long term.

That makes dividend stocks one of the very best investments you can have, and a strongly recommended foundation for your entire portfolio. You can hold other investments, but dividend stocks should represent a core holding.

Dividend Stocks vs. Growth Stocks

Now, I do have to make an important distinction here about appreciation. Dividend stocks typically don’t rise in price as much as growth stocks. That’s because—as the name implies—growth stocks are all about growth. They pay either little in dividends or even none at all. Instead, all profits are reinvested back into the business to expand revenue and profits.

Some of the best-performing stocks over the past decade have been growth stocks that pay no dividends at all. A good example is Amazon (AMZN). It doesn’t pay a dividend, but its stock price has increased from $170 per share 10 years ago to well over $3,000 now.

Though you may want to hold a number of these stocks in your portfolio, remember that you won’t get any income from them until the day you sell. That’s when you’ll get the benefit of the appreciated value. Until then, it’s just paper profit.

So, if you’re looking for passive income, dividend stocks are the better choice of the two.

2. Favorable Income Tax Treatment

In addition to paying yields well above those offered on interest-bearing securities, dividend-paying stocks also offer certain tax benefits.

Ordinary dividends are taxable as ordinary income for federal tax purposes. But, qualified dividends get the benefit of the lower long-term capital gains tax rate.

To be a qualified dividend, the stock must be issued by either a US corporation or by a foreign corporation whose stock trades on a US-based exchange. You must also own the stock for at least 60 days for the dividends paid on it to be considered qualified.

For qualified dividends the tax rates are as follows:

  • 0% if your taxable income is $78,750 or less.
  • 15% if your taxable income is greater than $78,750 but less than $434,550 if you’re single, or $488,850 if you’re married filing jointly, or a qualified widower.
  • 20% if your taxable income exceeds the above thresholds.

Of course, those lowered (or nonexistent) tax rates won’t matter if you’re holding your dividend stocks in a qualified tax-deferred retirement plan. But, they’ll be a big advantage if you’re holding them in a taxable investment account.

Warning Dont Chase High Dividend Yields!

It’s very easy to fall into thinking that goes something like this: if high dividends are good, higher dividends are even better.

In reality, the opposite is true. If any entity is paying significantly more than 3% or 4%, the risk of owning it will increase.

Earlier, I touched on how companies paying excessive dividends, or dividend payouts that exceed their net income, could be headed for trouble, and it’s worth repeating. If the company’s dividend yield is excessive, there’s an excellent chance they’ll cut the dividend, which will almost certainly collapse the share price.

Similarly, step lightly with master limited partnerships (MLPs). These are publicly traded partnerships that invest primarily in energy-related businesses and real estate since both groups have been providing high dividend yields. But, these partnerships are not only invested in highly speculative sectors, but they’re also often highly leveraged.

Put another way, high dividend yields may mask underlying weaknesses.

Another source of potential high-yield dividends are closed-end funds, so-called because the fund cannot issue any new shares. But, that means the price of a share will rise or fall—sometimes dramatically—based on investor interest or the lack of it. The share price may not match—or even come close to—the net asset value of the fund.

An even bigger potential problem is the ability to sell a closed-end fund, based on finding a willing buyer on the market. Unlike ETFs, the fund will not automatically buy back any shares you want to liquidate.

The attraction of closed-end funds is that they often pay high dividend yields. But, the risks associated with them, just like with stocks with excessive yields or MLPs, make them less reliable over the long term.

How much do I need to invest to live off of dividends?

Historically, dividend growth outpaces inflation, which is good news considering that inflation can functionally make your income worth less than what you put into it. Additionally, stock dividends grow over time, so the longer you hold onto your investment, the greater your return. Given the market’s historic upward trend, this may be a good strategy for a long-term investment.

Say you bought 1,000 shares of stock each valued at $100, held on to them long enough, and reinvested your dividends as well, you could earn a significant income stream over time. That’s a lot of what-ifs, however. Most people’s contributions to their retirement funds are more gradual, so your revenue stream will not be as significant as someone investing a lump sum of $100,000 when they’re 30. Nonetheless, you can significantly augment your income with consistent investments into dividend stocks over time.

What are the Dividend Aristocrats?

The Dividend Aristocrats refers to a group of companies from the S&P 500 that have increased dividends per share for at least 25 consecutive years. The S&P 500 Dividend Aristocrats ETF (NOBL) allows investors to easily purchase these companies that have consistently rewarded shareholders.

To be included in the dividend aristocrat group, certain criteria must be met:

  • Companies must be a member of the S&P 500.
  • Must have increased the annual total dividend per share for at least 25 straight years.
  • Must have a float-adjusted market capitalization of at least $3 billion.
  • Must have an average daily trading amount of at least $5 million.

The list of dividend aristocrats comprises 65 companies (as of March 2022) and includes well-known brands such as Coca-Cola (KO), Walmart (WMT) and International Business Machines (IBM), as well as lesser-known companies like Illinois Tool Works (ITW) and Expeditors International of Washington (EXPD).

Capital Gains

Sometimes, especially in the case of a special, large dividend, part of the dividend is declared by the company to be a return of capital. In this case, instead of being taxed at the time of distribution, the return of capital is used to reduce the basis of the stock, making for a larger capital gain down the road, assuming the selling price is higher than the basis.

For instance, if you buy shares with a basis of $10 each and you get a $1 special dividend, 55 cents of which is return of capital, the taxable dividend is 45 cents, the new basis is $9.45 and you will pay capital gains tax on that 55 cents when you sell your shares sometime in the future. 

There is a situation, though, where return of capital is taxed right away. This happens if the return of capital would reduce the basis below $0. For instance, if the basis is $2.50 and you receive $4 as a return of capital, your new basis would be $0, and you would owe capital gain tax on $1.50.

The basis is also adjusted in the case of stock splits and stock dividends. For the investor, these are treated the same way. Taking our 10% stock dividend example, assume you hold 100 shares of the company with a basis of $11. After the payment of the dividend, you would own 110 shares with a basis of $10. The same would hold true if the company had an 11-to-10 split instead of that stock dividend.

Dividend-capture strategies

You may wonder if there is a way to capture only the dividend payment by purchasing the stock just prior to the ex-dividend date and selling on the ex-dividend date. That’s not entirely correct.

Remember that the stock price adjusts for the dividend payment. Suppose that you buy 200 shares of stock at $24 per share on February 5, one day before the ex-dividend date of February 6, and you sell the stock at the close of February 6. The stock pays a quarterly dividend of $0.50 per share. The stock price will adjust downward on February 6 to reflect the $0.50 payment. It’s possible that, despite this adjustment, the stock could actually close on February 6 at a higher level. It is also possible that the stock price could close February 6 at a level lower than the $23.50 price suggested by the $0.50 adjustment to reflect the $0.50 dividend.

For the sake of this example, assume the stock adjusts perfectly and you sell at $23.50 per share. Are you better or worse off for capturing the dividend? You will receive $0.50 per share in the dividend, but you’ll lose $0.50 per share because of the decline in the stock price. It would appear to be a wash. But what about taxes? In order to receive the preferred 15% tax rate on dividends, you must hold the stock for a minimum number of days. That minimum period is 61 days within the 121-day period surrounding the ex-dividend date. The 121-day period begins 60 days before the ex-dividend date. When counting the number of days, the day that the stock is disposed is counted, but not the day the stock is acquired.

If the stock is not held at least 61 days in the 121-day period surrounding the ex-dividend date, the dividend does not receive the favorable 15% rate and is taxed at your ordinary tax rate.

To recap your dividend capture strategy:

  1. You paid $4,800 (plus commission) to purchase 200 shares of stock.
  2. Because you bought before the ex-dividend date, you’re entitled to the dividend of $0.50 per share, or $100. But because you didn’t hold the stock for 61 days, you’ll pay taxes at your ordinary tax rate. Let’s assume you are in the 28% tax bracket. That means your take after taxes is $72.
  3. You sold 200 shares at $23.50 for $4,700, a loss of $100 (plus commissions). You now have a “realized” short-term loss, which you can offset against realized capital gains or, if you have no realized gains, up to $3,000 of ordinary income.

In this case, the dividend-capture strategy was not a winner. You’re out the commissions to buy and sell the shares, you have a realized loss that you may or may not be able to write off immediately (depending on the amount of realized gains and losses you already have), and you lose the preferred 15% tax rate on your dividends because you didn’t hold the stock long enough.

The relationship between dividends and market value

Dividend-paying stocks provide a way for investors to get paid during rocky market periods, when capital gains are hard to achieve. They may provide some hedge against inflation, especially when they grow over time. They are tax advantaged, when compared to some other forms of income, such as interest on fixed-income investments. Dividend-paying stocks, on average, tend to be less volatile than non-dividend-paying stocks. And a dividend stream, especially when reinvested to take advantage of the power of compounding, can help build wealth over time.

However, dividends do have a cost. A company cannot pay out dividends to shareholders without affecting its market value.

Think of your own finances. If you constantly paid out cash to family members, your net worth would decrease. It’s no different for a company. Money that a company pays out to shareholders is money that is no longer part of the asset base of the corporation. This money can no longer be used to reinvest and grow the company. That reduction in the company’s “wealth” has to be reflected in a downward adjustment in the stock price.

A stock price adjusts downward when a dividend is paid. The adjustment may not be easily observed amidst the daily price fluctuations of a typical stock, but the adjustment does happen. This adjustment is much more obvious when a company pays a “special dividend” (also known as a one-time dividend). When a company pays a special dividend to its shareholders, the stock price is immediately reduced. 

Dividend Yield Formula

If a stock’s dividend yield isn’t listed as a percentage or you’d like to calculate the most-up-to-date dividend yield percentage, use the dividend yield formula. To calculate dividend yield, all you have to do is divide the annual dividends paid per share by the price per share.

Dividend Yield = Annual Dividends Paid Per Share / Price Per Share

For example, if a company paid out $5 in dividends per share and its shares currently cost $150, its dividend yield would be 3.33%.

You can find a company’s annual dividend payout in a few different ways:

  • Annual report. The company’s last full annual report usually lists the annual dividend per share.
  • Most recent dividend payout. If dividends are paid out quarterly, multiply the most recent quarterly dividend payout by four to get the annual dividend.
  • “Trailing” dividend method. For a more nuanced picture of stocks with changing or inconsistent dividend payments, you can add up the four most recent quarterly dividends to get the annual dividend.

Keep in mind that dividend yield is rarely consistent and may vary further depending on which method you use to calculate it.

What is a good dividend yield?

A solid dividend yield in the S&P 500 is 2.5 percent. It’s important to remember that the stock price can grow significantly more than your dividend yield, so that the appreciation of your investment is greater than the amount you make from dividends.

Is Living Off Dividends a Good Idea?

While there’s something instinctively satisfying about living solely off dividends, it’s usually not necessary to distinguish between living off dividends versus a portfolio of equities in general.

How Much Do You Need to Invest to Live Off Dividends? 💸 Click To Tweet

In truth, there’s no practical difference between distributing money from your portfolio through dividends or through selling assets.

🤔 Think of it this way: Your dividend yield is just a portion of the total return on your portfolio. If you have a 10% return, it doesn’t matter whether it breaks down to 5% value growth and 5% dividend yield or 9% value growth and 1% dividend yield. In other words, if an asset pays you a dividend of $500 and you reinvest it, that’s the same as if the shares increased such that your position’s value went up by $500. The difference, of course, is that a dividend is relatively predictable, while appreciation is not.

The only difference to an investor would come from a variance in tax rates when taking distributions from a taxable brokerage account. In most cases, though, that will work out in favor of selling assets over taking dividends anyway.

If you manually sell portions of your retirement portfolio, you can use the first-in, first-out basis, which means the first asset you sell is the first one you acquired. These should always be subject to long-term capital gains taxes if you’ve been investing for years. 

Meanwhile, ordinary dividends are subject to the less favorable ordinary income tax rates.

You’ll also have more control over the timing of your earnings if you sell portions of your portfolio manually. Shareholders don’t get to decide when they receive their dividends or how much they’ll be.

So while you can live off the dividends from your investments, it might not be the optimal retirement strategy. You’re generally better off optimizing your portfolio’s total return than you are chasing a high dividend yield just for the sake of dividends.

📘 If you prefer a buy and hold strategy but you still want market-beating growth, there’s a variant of dividend investing that you should consider – Dividend growth investing

Dividend Tax Considerations

Don’t forget to factor taxes into your dividend calculations. If you’re receiving your dividends from equities in a traditional 401(k), IRA, or taxable brokerage account, they will be taxable income.

However, they’ll be subject to different tax rates. With a traditional retirement account, you won’t pay taxes on dividends while you reinvest them. Once you start taking them as distributions, though, they’ll be taxable at ordinary income rates.

If you take your dividends from a taxable brokerage account, they will receive one of two tax treatments, depending on whether they are:

  • Qualified: These are taxable at the discounted long-term capital gain rates of 0%, 15%, or 20%.
  • Ordinary: These are taxable at ordinary income rates, which range from 10% to 37%.

If your dividends come from after-tax accounts like Roth 401(k)s or IRAs, you can avoid the issue altogether. You won’t pay taxes on reinvested dividends or those you take as distributions.

Make sure you know the significance of these two types of taxation, as they can skew your numbers significantly.

👉 For example, $30,000 in qualified dividends taxable at 15% is $25,500. The same amount in ordinary dividends taxable at 24% is $22,800. That’s $2,700 less each year and $225 less per month.

It’s always a good idea to get personalized tax advice regarding the implications of any investment strategy. Consider discussing your approach with a tax expert like a Certified Public Accountant or Enrolled Agent, or read what the IRS has to say about dividends.

📘Learn More: If you need to brush up on the different types of personal income taxes, take a look at our overview of the subject: Taxation 101: How Do Taxes Work For Individuals?

Bottom line

Dividends can have a big impact on your portfolio over time. They can help generate income during retirement or earlier and can also be reinvested to increase your total investment return. Consider owning dividend-paying companies through a low-cost fund or ETF in a tax-advantaged account as part of your long-term investment plan.

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Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.

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