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How do dividends work?

Learn about the different types, how they're applied and how you're taxed on the revenue.

When you buy stock in a company, you’re effectively buying a piece of that company. Your piece makes you a part-owner, and 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 affect your taxable income in this guide.

What is a dividend?

A dividend is a portion of a company’s earnings returned to shareholders as a cash payment into a trading account. Dividends are typically distributed to shareholders quarterly, though some companies pay out dividends monthly or even twice a year.

The size of the dividend you receive is in proportion to the number of shares you own. For example, Hershey (HSY) paid a quarterly dividend of $0.773 for each share held on February 20, 2020. If you owned 1,000 shares, you’d have received a dividend of $773. For 10,000 shares, your dividend payment would have been $7,730.

What is the ex-dividend date?

To receive a company’s dividend payout, you must hold or own the shares prior to its ex-dividend date. If you buy shares on or after the ex-dividend date and hold them to the next date, you are eligible for the next dividend payment, if there is one.

Not all companies pay dividends

Dividends are not guaranteed to shareholders. Companies decide what the value of a dividend will be, if they decide to payout a dividend at all. Also, just because a company pays a large dividend one quarter or year doesn’t mean it will do it again the next time.

Smaller or newer companies may choose to reinvest any profits into the company to help it grow, rather than pay shareholders a dividend. This tactic is also good for investors, because if the company’s growing, the value of its stock will likely grow too.

What is the dividend yield?

The dividend yield is a percentage that indicates the value of a dividend payment in relation to the cost of the stock. It’s calculated by determining what percentage of the stock price is returned to the investor as income.

The dividend yield helps investors compare similar companies, helping to give you an idea of which one offers a better return on your money in the form of a dividend.

Dividend yield example

Let’s go back to our Hershey stock, with its dividend payment of $0.773 per share. The stock price at the time of the ex-dividend date was $160.11 per share, which results in a 1.9% dividend yield.

Because the yield is calculated using the stock price, it changes daily as the stock price changes. In contrast, the average dividend yield for S&P 500 stocks has been around 2% for the last decade.

Types of dividends

Dividends come in different types, but not all companies pay all — or any of them to shareholders:

  • Cash dividend. The most common dividend, it’s paid directly to your investment account as cash.
  • Stock dividend. This dividend payment is paid in additional shares of stock, rather than cash.
  • Property dividend. These are payouts of physical property, such as a product that has a fair market value.
  • Scrip dividend. If short on cash, a company can issue a promissory note to pay the dividend at a future date along with interest.
  • Hybrid dividend. This can be a combination of any other dividend, though it’s often a mix of cash and stock.

Paying tax on dividends

Because dividend payments are a form of income, you must report them as taxable income when you file your tax return.

How much they’re taxed, however, depends on the type of dividend and your tax bracket:

  • Qualified dividends. Issued by US companies or US-listed companies, these dividends are taxed as long-term capital gains. In 2020, rates were 0%, 15% or 20%, depending on your tax filing status and income.
  • Nonqualified dividends. Other dividends are taxed as a short-term capital gain at regular income rates — from 10% to 37%, depending on your tax filing status and income.

Dividend totals are typically reported to you by your brokerage account on Form 1099-DIV or Form K-1.

How does a dividend reinvestment plan work?

Some companies offer what’s called a dividend reinvestment plan — commonly called a DRIP. A drip allows you to opt-in to using your dividends to buy more shares of stock in the company instead of receiving the dividend payment as cash.

In this way, you’re able to use the money to buy more stock without paying brokerage fees. It’s also a passive way to increase your position in a company gradually over time with little effort. Once you opt in, it all happens in the background automatically.

A downside of opting into a DRIP is that you don’t get to choose the price at which you’d like to buy more shares of stock. Instead, they’re automatically bought on your behalf on the date of the dividend payment.

How to compare dividend-paying stocks

When comparing dividend-paying companies, answer four key questions to better understand what to expect:

  • How often are dividends paid? Most US companies pay dividends quarterly, but it’s not uncommon for overseas companies to pay dividends once or twice a year or even monthly.
  • Has the company declared dividends? Companies will often declare their dividend payments weeks or months 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, it’s a sign the company is growing and will potentially continue to increase its dividend.
  • What’s the dividend yield? Depending on the yield, you might be able to outpace your passive earnings on a high-interest savings account.

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Bottom line

Dividends can add value to a stock, providing the opportunity for an ongoing stream of income or reinvesting for faster compounding over time. But not all dividends are alike.

If dividends are important to you, research a company’s history of dividends and the type of dividend it typically pays to see if it’s best for your portfolio and investment strategy. Then compare your trading platform options to find the best fit for your goals and experience.

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