What Are Dividends?

Dividends are payments a company can make to its shareholders on a regular basis. This arrangement can benefit both the company, which can attract future investors, and the shareholder, who can earn a return without selling their shares.

Individual stocks may pay dividends, and some mutual funds and ETFs do, too, if they hold dividend-paying stocks.

How do dividends work?

A company typically pays dividends on a per-share basis. For example, if you own 50 shares in a company's stock and the company's board of directors announces a cash dividend of $2 per share, you'll receive $100. 

Here's a quick overview of how the dividend process works:

• The company earns profits. Its board of directors may then approve a plan to share profits in the form of dividends. The board decides how much to pay and whether shareholders will receive dividends monthly, quarterly, or semiannually.

• The company announces details about the dividend. These details include the dividend amount, the payment date, the date of record, and the ex-dividend date, which is the first day that shareholders purchasing stock are not eligible to receive the dividend. 

• The company pays the dividend. Each eligible shareholder receives the dividend amount for each share they own. 

You can choose to accept the dividend payment as cash in your brokerage account, or reinvest the dividend into your portfolio to purchase more of the stock. 

Companies can pay dividends on a regular schedule or issue special one-time dividends when it has excess profits. The most common type of dividend is a cash dividend, but companies may pay other types of dividends, too. However, it’s important to note that there is no assurance a dividend will be paid just because one has been paid in the past.

Dividend yield explained

The dividend yield is a ratio that can help investors judge the value of investing in a particular stock. It shows how much you earn through dividend payouts each year for every dollar invested in a stock, a mutual fund, or an ETF. The dividend yield is expressed as a percentage. Investors typically consider 2% to 6% as a good dividend yield, but several factors can influence whether a stock is a good investment. 

Stock research tools often list a company's dividend yield, but it's not difficult to calculate this ratio on your own. 

How to calculate dividend yield

To determine a stock's dividend yield, divide the annual dividend by the price per share:

Annual Dividend/Price Per Share = Dividend Yield 

For example, if a company paid out $10 in dividends and its shares currently cost $200, its dividend yield would be 5%:

$10/$200 = 0.05 or 5%

To find a company's annual dividend payout, check the company's annual report. If the company pays dividends quarterly, then add up its four most recent dividend payments to get the annual dividend. Keep in mind that because stock prices fluctuate regularly, the dividend yield will also vary. 

Understanding dividend payout ratio

The dividend payout ratio shows how much of a company's total net income is paid out to shareholders as dividends, and how much is retained by the company to invest in growth or pay off debt. This ratio can demonstrate the sustainability of a company's dividend payments. 

A company that doesn't pay dividends has a dividend payout ratio of 0%, while a company that pays all its profits in dividends has a dividend payout ratio of 100%. A rate close to 100% may sound great in theory. But it may indicate the company is struggling and may have to take on debt to continue paying its dividends. This could be a sign the company may soon pause or cut dividend payments. Generally, a payout ratio that's under 50% shows that a company can reward its shareholders and still have room to invest in growth initiatives.

How to calculate dividend payout ratio

To calculate a company's dividend payout ratio, divide its net income by its total dividend payments for the year:

Dividend Payments/Net Income = Dividend Payout Ratio

For example, if a company had $1 million in net income during the previous year and paid $400,000 toward dividends in that timeframe, then its dividend payout ratio is 40%:

$400,000/$1,000,000 = 0.40 or 40%

Another way to calculate the dividend payout ratio is by taking the company's earnings per share and dividing it by the dividend per share:

Dividend Per Share/Earnings Per Share = Dividend Payout Ratio

For both formulas, you can find the details you need in a company's cash flow statement or its dividend announcement. 

What are qualified dividends?

A qualified dividend is a type of dividend that receives preferential tax treatment. It's subject to the same tax rates as long-term capital gains, which are lower than ordinary income rates. The stock must be held for a minimum holding period to be considered a qualified dividend. That holding period can vary, but it's usually at least 61 days out of a 121-day period that begins 60 days before the ex-dividend date. 

Additionally, the dividend typically must be received from common and preferred shares of U.S.-based corporations and qualified foreign corporations. 

Qualified vs nonqualified dividends

The benefit of qualified dividends is that they're taxed at capital gains tax rates rather than regular tax rates. For many taxpayers, the capital gains tax rates are lower than their ordinary tax rates. 

The maximum capital gains tax rate is 20% in most cases, while the maximum income tax rate is 37%. Nonqualified dividends are taxed at the shareholder's ordinary income tax rate.  

Dividend investing: How it works

Dividend investing is an investing strategy where you focus on purchasing stocks, ETFs, or mutual funds that pay significant dividends. When investors own stocks that pay dividends, they receive regular income from their investments, in addition to any growth in their investment portfolios if they gain value over time. 

When you purchase shares of a dividend-paying company, you can often expect to receive a percentage of the company's profits as a dividend on an annual or quarterly basis. You can choose whether to keep the dividends in cash or have them automatically reinvested into your portfolio. By reinvesting dividends, you take advantage of dollar-cost averaging, which allows you to regularly purchase stock at various levels of the market, which typically equates to lowering your average cost per share.  

Reinvesting dividends can help fuel growth in an investment portfolio, and Acorns Invest accounts reinvest dividends by default. You can also choose to have dividends flow into a cash account if you need the income. 

How are dividends taxed?

All dividends are considered taxable income. Qualified dividends are subject to capital gains tax rates, and all others are subject to ordinary income tax rates.  

There are ways to avoid paying taxes on dividends right away or avoid paying them at all. For example, a dividend that is marked as a return of capital is not taxed until the shareholder sells the underlying investment. A return of capital means the company is returning part of your original investment, rather than paying out earnings on that investment. These are common with real estate investment trusts (REITs), stock splits, and stock buybacks. 

Also, if you own the dividend-paying stock or fund in a tax-advantaged account, you can defer taxes on any dividends received. For example, if dividends are paid on assets you hold in a traditional IRA, simplified employee pension (SEP) IRA, 401(k) plan, or 529 education savings account, you will not have to pay taxes on the dividends until you withdraw funds from the account. With a Roth IRA or Roth 401(k), you won’t have to pay taxes on dividends earned in those accounts, as long as you follow the qualified withdrawal rules. 

How often are dividends paid?

Companies that pay regular dividends usually do so on a quarterly basis. Some pay monthly, biannually, or annually. There are several important dates involved in the timing of dividend payments. 

• Declaration date: When the board of directors agrees on the amount of a dividend payment, the company officially announces its next dividend. The day of that announcement, or declaration, is the declaration date. 

• Record date: The record date is the date on which you must own shares in the company in order to receive the dividend payment. 

• Ex-dividend date: The first day that shareholders purchasing stock are not eligible to receive the dividend. The ex-dividend date is one day before the record date. 

• Payment date: The dividend is distributed to shareholders on the payment date. 

Investing in dividend stocks or dividend funds can be a valuable strategy for building long-term growth. Many of the funds available in an Acorns Invest account pay dividends to help increase total investment returns.