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What are dividends and how do they work?

Dividends allow investors to enjoy a share of a company's earnings. Here's how they work and how they can benefit you.

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When you buy shares in a company, you’re effectively buying a piece of that company which means you’re a part-owner. As a shareholder you’re entitled to a share of the company’s earnings, which comes in the form of dividends.

Learn about the different types of dividends, how they’re applied and how they impact your taxable income in this guide. Plus, compare a range of online share trading platforms which allow you to start buying shares in companies that pay dividends.

What is a dividend?

A dividend is a share of a company’s earnings given to shareholders as a cash payment into their bank account, usually twice a year. The size of the dividend you receive is in proportion to the number of shares you own. The more shares you own the bigger your dividend payment will be.

For example, let’s pretend a company that sells items for household pets called Pets Galore is offering a dividend payment of $0.05 for each share held. If you owned 1,000 shares, you’d receive a dividend of $50. However if you owned 10,000 shares, your dividend payment would be much larger at $500.

What is the ex-dividend date?

In order to receive a company’s dividend payment, you must hold the shares prior to its ex-dividend date. If you buy shares on or after an ex-dividend date, you will be eligible for the next dividend payment, if there is one.

Not all companies pay dividends

Instead of paying shareholders a dividend, a lot of smaller, newer companies will reinvest any profits made back into the company to help it grow. However, many investors are okay with this because if the company is growing, the value of their shares will grow too.

It’s also important to note that dividends are never guaranteed. Each company decides what the value of the dividend will be and if there will even be a dividend payment at all, annually. So just because a company pays a large dividend one year, it doesn’t mean it will do this again the following year.

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What is the dividend yield?

The dividend yield is presented as a percentage and is an indication of the value of the dividend payment in relation to the cost of the shares. The dividend yield is calculated by determining what percentage of the share price is returned to the investor as income. The dividend yield helps investors compare similar companies, as it gives you an idea of which one offers a better return on your money in the form of a dividend.

Dividend yield example

Let’s look at company Pets Galore again with its dividend payment of $0.05 per share. If the current share price was $2 per share, the dividend yield would be 2.5%. If the share price was instead $0.50 per share, the dividend yield would be a lot better at 10%. Because the yield is calculated using the share price, the yield will change daily as the share price changes.

Types of dividends

There are 3 main types of dividends, but not all companies will pay all 3 types to shareholders (and some won’t pay any at all!).

  • Interim dividend. This is a dividend that’s paid before the company has calculated its annual earnings. It’ll usually be paid at the same time as the company’s interim financial statements, usually 6 months into the financial year.
  • Final dividend. This dividend payment is paid when a company announces its profits for the full financial year. Some companies will only pay a final dividend.
  • Special dividend. These are bonus dividends and are typically larger than the normal dividends paid out by a company. A company may issue a special dividend to shareholders when it achieves higher-than-normal profits across a certain period.

Paying tax on dividends

Because dividend payments are a form of income, you do need to include these in your total taxable income when you file your tax return. However, there are some important guidelines to keep in mind when figuring out what investment income to declare and how much tax you’ll have to pay:

  • In Canada, you only have to declare investment income when it’s realized – or when you actually sell a share and make a profit. When your shares increase in value but you hold on to them instead of selling, you don’t make any money. This is considered unrealized income and isn’t taxable.
  • A capital gain occurs when your assets increase in value. In Canada, you’re only taxed on 50% of realized capital gains. So, if you buy 10 shares and each share increases in value by $3, you would have a capital gain of $3 X 10 = $30. But, you would only have to pay income tax on 50% of $30, which is $15.
  • You can use capital losses to offset your tax owing. A capital loss occurs when you lose money on your assets (for instance, if your shares decrease in value). If you buy 5 shares and the value of those shares goes down by $2, you would have a capital loss of $2 X 5 = $10. You can subtract this from your capital gains and only have to pay income tax on the resulting amount. Continuing the above example, this means you’d only have to pay income tax on $30 – $10 = $20.

How does a dividend reinvestment plan work?

Some companies offer what is called a dividend reinvestment plan (known as a DRIP), which allows you to opt in to using your dividends to buy more shares in the company, instead of receiving the dividend payment in your bank account.

There are several advantages of doing this, but th main one is you’re able to use the money to buy more shares without paying any brokerage fees. It’s also a good, passive way to increase your position in a company gradually over time with little to no effort from you. It’s a good set-and-forget investment strategy: once you opt in, it all happens in the background automatically.

One downside of opting in to a DRV is you’re unable to use that cash for day-to-day purchases like you could if you had received it into your bank account. You also don’t get to choose at what share price you’d like to buy more shares: the shares are automatically bought on your behalf on the date of the dividend payment.

How to compare dividend-paying shares

If you’re comparing a bunch of dividend-paying companies, here are a few things to keep in mind.

  • How often are dividends paid? Some companies pay dividends several times a year, while others only pay once.
  • Have dividends been confirmed? Companies will often confirm their dividend payments for the year ahead in advance.
  • Are dividends growing in value? Take a look back at the dividends paid by each company over previous years. If the value of the dividend has gradually increased, this is a good sign the company is growing and will likely continue to increase its dividend.
  • What’s the dividend yield? Is the yield higher than what you could earn with a high interest savings account?
  • Is it fully franked? If the dividends aren’t fully franked, when you file your income tax return you won’t receive a credit and you’ll need to pay the full income tax on the dividend yourself.

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Disclaimer: This information should not be interpreted as an endorsement of futures, stocks, ETFs, CFDs, options or any specific provider, service or offering. It should not be relied upon as investment advice or construed as providing recommendations of any kind. Futures, stocks, ETFs and options trading involves substantial risk of loss and therefore are not appropriate for all investors. Trading CFDs and forex on leverage comes with a higher risk of losing money rapidly. Past performance is not an indication of future results. Consider your own circumstances, and obtain your own advice, before making any trades.

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