Are you thinking about investing in dividend stocks? It could be a great investment strategy because dividend stocks allow you to generate steady income as a result of investing in stable companies.
What are dividend stocks, exactly? Dividends are structured payments typically made regularly to shareholders by a publicly traded company. These payments come out of a company's profits. Companies pay out company earnings directly to shareholders. Shareholders can cash them out or reinvest them. It’s a good idea to understand how dividends actually work before you get started investing.
Let’s go over the definition of a dividend, why companies pay dividends, how dividend stocks work, how they’re paid out and more. By the end of the article, you’ll have a clearer idea to the prevailing question, "Why buy dividend stocks?”
Why Dividends Matter
Companies pay dividends as a way to share their profits with investors and encourage them to continue to invest in the company. You can think of it as a “thank you” from a company for being an investor.
Let’s examine growth and expansion of profits, risk and volatility, various ways to receive payments, dependability, possible tax benefits and things to consider when choosing dividend stocks.
Reason 1: Growth and Expansion of Profits
How do dividends work, exactly?
When companies offer dividends, they usually offer cash dividends on a per-share basis to investors. Let’s say a company pays a dividend of 90 cents per share. If you had purchased 100 shares of that company's stock, you would receive $90 in cash. Another example: If you have 100 shares and the company issues a 5% stock dividend, you’d have 105 shares after the dividend. The number of shares you own determines your total payout. Sometimes, companies offer shares instead of cash payments.
It’s important to note that you won't be guaranteed a dividend, ever — even if you're investing in one of the Dividend Aristocrats or Dividend Kings, which are considered some of the most stable companies on the stock market.
However, it’s important to note that not all stocks pay dividends. New companies, such as startups, will not necessarily pay a dividend. Most new companies want to reinvest as much as possible back into the company instead of paying dividends.
Pro tip: Shareholders who hold preferred stock have a “more prominent” claim on a company’s assets compared to common shareholders. There are different rights for preferred stockholders compared to common stockholders. In good times and bad, preferred shareholders are repaid first prior to common shareholders.
Reason 2: Reduce Risk and Volatility
Dividend payments, particularly high dividends, might mitigate any losses that occur from a decline in stock price.
However, it’s important to remember that dividend stocks (even high dividend stocks) aren’t immune to risks in the stock market, especially during times of economic turmoil like wars or pandemics. (For that reason alone, it’s easy to understand why investors might gravitate toward exchange-traded funds, IRAs or index funds instead because they can access more diversification through those types of investments.)
It’s also important to recognize that companies don’t start issuing dividends until they reach a significant size and level of stability. Often, young, fast-growing companies prefer not to pay dividends, opting instead to reinvest their retained earnings into business operations. They opt to try compounding their growth first and aim to offer dividends later on.
Reason 3: Can Tap into Various Ways to Receive Payouts
As mentioned, the two major dividend payments include cash payments or additional shares of stock. You may find out about dividend payments through press releases, the company’s website or through major stock quoting services.
You can receive dividend payments in several ways: You may receive additional shares of stock instead of dividend payments. This is called dividend reinvestment, called a dividend reinvestment plan (DRIP).
There are other methods of dividend payments, including special dividends, which are a bonus on top of regular dividends. It may happen if the company is having a good financial run. Special dividends usually occur in the form of cash payments and are usually larger than regular dividend payments.
Companies might also offer real estate or another type of physical asset through property dividends or you might get a choice of cash or company stock through a scrip dividend.
Reason 4: Possible Dependable Source of Income
Companies that pay dividends usually offer them quarterly, though some pay monthly or semiannually. Dividend payments usually come by check, which is mailed to stockholders a few days after the ex-dividend date. The ex-dividend date, also called the ex-date, is the date which determines whether you receive a dividend for a purchased stock or not.
If a dividend is declared, here are some key dates that an investor should look for. A company’s board operates on four main “dates” for dividend-paying stocks — the declaration date, the ex-dividend date, the record date and the payment date.
In addition to the ex-dividend date, it’s a good idea to know a few others, including the declaration date, record date and payment date. The declaration date is the date in which the board of directors of a company authorizes dividend payments to go to shareholders. The record date is the final date that you must be considered as a shareholder in order to receive the dividend. Companies also declare a payment date — the date that you’ll get payment by companies.
On the payment date, the company deposits the funds with the Depository Trust Company (DTC), which goes to brokerage firms to shareholders’ client accounts.
Reason 5: Possible Tax Benefits
You must pay taxes on dividends but how much they pay depends on whether the dividends are qualified dividends or ordinary dividends.
Qualified dividends are taxed at long-term capital gains tax rates for stocks held for a certain amount of time.are taxed at the capital gains tax rate. You’ll be taxed at either 0%, 15% or 20%, depending on your personal income tax bracket.
An ordinary dividend simply refers to a scheduled payment made by a company to its shareholders. Ordinary dividends, also called non-qualified dividends, will be taxed at your regular marginal income tax rate.
In the tax year 2022, ordinary dividends are subject to standard federal income tax rates — 10% to 37%, which is what they pay on regular income.
Taxes vary depending on the type of dividend the company declared, the account type you have and how long the shareholder has owned the shares. These dividends are summarized for each tax year on Form 1099-DIV.
Things to Consider When Choosing Dividend Stocks
It’s important to think carefully about how dividend stocks work before you choose to invest in dividend stocks. You’ll want to consider dividend yield, stock price, fundamentals of the company and more.
- Dividend yield: You’ll want to know the annual dividend yield of each stock you’re considering. The dividend yield refers to a financial ratio that shows how much a company pays out in dividends each year relative to its stock price. In fact, you’ll want to rely on a solid set of dividend stock selection criteria before you choose to enter partnerships as a stockholder.
- Stock price: The share price is an important consideration. How much does it cost to buy? Is it more advantageous to buy ETFs for the low share price? Your brokerage account can help you determine the share price, depending on when you buy, immediately with a market order or with a limit order, or when you buy at a specific price. It’s a good idea to never sink all your money into one stock. If you’re expecting dividend income to roll in. You might automatically gravitate toward the Dividend King and Dividend Aristocrat lists. Even if you invest in the Dividend Aristocrats or Dividend Kings, it can still be a risky move because you’re sinking your money into single stocks.
- Fundamentals: Peer into financial statements, various company’s prospectuses and get as much detailed information as you can about the companies you’re considering. Check for long-term profitability, a company’s balance sheet and debt (by examining the company’s debt-to-equity ratio), check sector trends (such as the impact of the aging baby boomer population or economic conditions for oil companies) and more.
Are there other factors to consider? Absolutely! It’s a good idea to do comprehensive research before you determine whether dividends work for you.
Read more: ETFs vs. Dividend Stocks
Should You Buy Dividend Stocks?
So, should you pursue dividend investing or look into something else completely, like real estate investment trusts (REITs) or ETFs? A company’s earnings and the company’s dividend should absolutely be a consideration when you consider dividends as part of your stock investing portfolio — as long as you do your research and you’re confident that dividend growth fits into your goals and investment objectives.
A financial advisor may help you decide whether dividend stocks make the most sense for you. A fiduciary financial advisor can help you decide what types of investments you should consider based on your goals and time horizon.
About Melissa Brock
While working in college admission, Melissa Brock pursued a freelance writing and editing career. She currently works as a full-time freelance writer and financial editor covering higher education, investing, personal finance, mortgages, college savings, insurance, and more.
She developed her website, College Money Tips
, to help families navigate the college journey. She connects with a wide-reaching audience through her site, through an upcoming digital course, and the myriad of publications for which she writes. Melissa graduated summa cum laude with a bachelor of arts in communication studies with minors in psychology and Spanish from Central College. She's a longtime member of the National Association of College Admission Counseling (NACAC).