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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.

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 portion of a company’s earnings distributed to shareholders, typically paid quarterly. However, some companies may pay dividends semi-annually or annually. 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.

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 say a company called Pets Galore pays an annual dividend of $1.00 per share.

  • If the company’s stock is trading at $20, the dividend yield would be 5% ($1 ÷ $20).
  • If the share price drops to $10, and the dividend stays at $1, the yield increases to 10% ($1 ÷ $10).

While a higher yield might seem attractive, a falling share price can also be a warning sign. It could reflect declining earnings, increased risk, or market concerns about the company’s future ability to maintain that dividend.

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:

  • You must declare dividend income in the year it is paid to you, regardless of whether you sell your shares. However, capital gains tax applies only when you sell shares and realize a profit. Unrealized gains (increases in share price that you haven’t sold) are not taxable. 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. Qualified dividends are taxed at favorable long-term capital gains rate — 0%, 15% or 20%, depending on your income. For example, if you buy 10 shares, each share increases in value by $3 and you sell them after holding more than a year, you’d have a $30 long-term capital gain, which would be taxed at these lower rates. If you sell them within a year, your gain is considered short-term and taxed at your ordinary income tax rate. Non-qualified dividends, such as those from real estate investment trusts (REITs) are taxed as ordinary income at your regular income tax rate.
  • 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. If your capital losses exceed your capital gains in a year, you can deduct up to $3,000 of the excess loss against other income on your tax return. Any remaining losses can be carried forward to future tax years.

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 brokerage account.

There are several advantages of doing this, but the main one is the automatic purchase of additional shares, creating a compounding snowball effect over time.

Since DRIP shares are bought automatically, one downside of opting in to a DRIP is the lack of control over the purchase price. This could mean buying at relatively high prices. While you don’t control the purchase price when reinvesting dividends through a DRIP, these plans often allow for commission-free purchases and fractional shares, which can help grow your investment steadily over time.

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?

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Alison Banney is the banking and investments editor at Finder. She has written about finance for over six years, with her work featured on sites including Yahoo Finance, Money Magazine and Dynamic Business. She has previously worked at Westpac, and has written for several other major banks including BCU, Greater Bank and Gateway Credit Union. Alison has a Bachelor of Communications from Newcastle University, with a double major in Journalism and Public Relations. She has ASIC RG146 compliance certificates for Financial Advice, Securities and Managed Investments and Superannuation. Outside of Finder, you’ll likely find her somewhere near the ocean. See full bio

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Stacie Hurst is an editor at Finder, specializing in loans, banking, investing and money transfers. She has a Bachelor of Arts in Psychology and Writing, and she has completed FP Canada Institute's Financial Management Course. Before working in the publishing industry, Stacie completed one year of law school in the United States. When not working, she can usually be found watching K-dramas or playing games with her friends and family. See full bio

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