Stock Dividend: What is it and how it works

When companies turn a profit, they have several choices with respect to next steps. One option is to reinvest the money to help grow the business. Another is to buy back some of their outstanding shares, often to raise their share price and create value for shareholders. A third option—detailed in this post—is to share profits with shareholders in the form of dividends.

While investing in stocks that pay dividends is perhaps appealing to an investor such as yourself, you should also keep in mind associated risks and potential tax implications.

An overview of stock dividends

A dividend is a payment a company makes to its shareholders, similar to a “bonus” or “reward” received for owning the stock.

A dividend is paid per share of stock. For example, if a company pays out $0.50 per share of stock and you own 100 shares, you’ll receive $50. Generally speaking, dividends are paid regularly—often quarterly—but not all stocks pay them, and companies may reduce or eliminate these at any time.

Types of stock dividends

A company can pay its shareholders several types of dividends.

The most common form is cash-based, such as in the previous example. With cash dividends, you’ll enjoy the option to reinvest them in additional company stock via a dividend reinvestment plan (DRIP). These programs automatically reinvest dividends for you to purchase fractional shares of company stock, which can accumulate over time.

Companies can also pay investors stock instead of cash, known as a “scrip dividend.” In this scenario, you’re paid based on the number of shares you own. For example, if the company offers a 5% scrip dividend and you own 1,000 shares, you’ll receive an additional 50 shares.

Another type of special dividend is a one-time payment that most commonly occurs when a company declares exceptionally strong earnings. Finally, preferred dividends are paid to owners of preferred stock (more on that later).

How to identify stocks that pay dividends

Dividends are often paid out by well-established companies with a history of growth and earnings: such as 3M Co. and Proctor & Gamble. Dividends are a great way for such companies to share their profits with investors—and an excellent tool to attract new ones! Conversely, as new or start-up companies are focused on growth, these types of organizations often reinvest their profits rather than pay out dividends. 

When you search for a company’s stock, related data will often include their dividend per share and dividend yield (which measures the value of the dividend compared to the stock price).

Types of investments that pay dividends

Common Stock
When you own at least one share of common stock, you are officially a company shareholder and therefore enjoy corporate policy voting rights and the ability to elect the organization’s board of directors.

A share of common stock, over the long term, also generally performs better than other types of ownership equity and can thus create significant returns for investors—making this an attractive investment! However, common stock is also sometimes the riskiest option since, in the event of bankruptcy, shareholders have a right to company assets only after bondholders, preferred stockholders, and other debtholders are paid in full.

Preferred Stock
Preferred stocks are more of a hybrid investment type given similar properties to both common stock and bonds. While preferred stock is purchased in the same way and pays out dividends just like common stock, the two differ in that dividends are agreed upon and paid at regular intervals for the former type. The market value of preferred stocks is also sensitive to interest rate changes.

An advantage of preferred stocks is that they pay a higher dividend rate than common stock issued by the same company. In addition, the issuing company must pay out preferred stock dividends before common share dividends. Preferred stockholders also rank higher than common stockholders in the event of liquidation. Preferred stocks are generally considered less risky than common stocks due to these benefits.

However, unlike common stock shareholders, preferred stock shareholders usually don’t have voting rights.

Mutual Funds
A mutual fund is a type of fund that pools money from investors to purchase securities. Investors buy fund shares or units, which are then invested and managed by a professional portfolio manager.

Mutual funds are often comprised of stocks, bonds, and short-term assets such as money market funds—or a combination of the three. Fund assets are referred to as “holdings” and vary based on fund objectives. For example, a small-cap fund comprised only of smaller company stocks is riskier than a large-cap mutual fund with holdings comprised of large company stocks.

Mutual funds are popular among many investors since they offer an easy way to diversify and distribute risk across several investments.

Benefits of investing in dividend-paying stocks

There are several reasons to invest in dividend stocks.

For starters, they can help protect against market risk as they at least offer you a near-guaranteed partial return on your investment—since it’s very rare for dividend-paying companies to stop paying them—while there is no guarantee stocks will increase in value. As a result, dividend stocks can also help reduce overall portfolio risk as they may mitigate any stock price declines.

Dividends can also offer tax advantages, depending on the stock and how long you’ve held that stock. For example, qualified dividends are taxed at long-term capital gains rates, which are lower than ordinary rates. If dividends are considered nonqualified, also known as “ordinary dividends,” they are taxed at your regular income rate.

To be considered a qualified dividend, the dividend must be paid by an American company or a foreign business that trades in or has a tax treaty with the U.S. You must also own the stock for at least 60 days prior to the ex-dividend date (also known as the ex-date), which is the deadline to buy a stock and receive the dividend.

Dividend stocks can also help shield you from inflation. For example, should your investment increase 2% over the year but inflation is 3%, dividends can help minimize or even protect you from that 1% loss. Many dividend-paying companies also offer dividend yields (calculated by dividing the dividend paid by the stock price) that outpace inflation.

Risks of investing in dividend-paying stocks

The biggest risk with dividend-paying stocks is interest rate risk, which is the potential for investment losses resulting from a change in interest rates. Generally, high-dividend stocks are more popular when interest rates fall and less attractive when the Federal Reserve hikes them up. Why? Because investors compare yields they can earn by holding a Treasury bond or other investments that offer a risk-free rate of return.

The bottom line on stock dividends

While investing in stocks that pay dividends is sometimes beneficial, the decision to incorporate them into your portfolio ultimately depends on your overall investment strategy.

Questions about how and where to invest your money? Schedule a FREE Discovery call with one of our CFP® professionals.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business. 

Preferred stock dividends are paid at the discretion of the issuing company. Preferred stocks are subject to interest rate and credit risk. As interest rates rise, the price of the preferred falls (and vice versa). They may be subject to a call feature with changing interest rates or credit ratings.