Dividends can be a regular source of income for investors, potentially offering a cushion in a down market or a boost in an up market. Here’s what dividends are and how they work, plus ideas for evaluating dividend stocks if you’re considering investing in them.
What is a dividend?
A dividend is a payment that certain companies distribute to their stock investors. By paying shareholders a portion of their earnings, businesses reward existing shareholders. Dividends could also potentially attract new investors who are looking for income-producing investments or want to invest in a company with strong financials. While many dividend-paying companies are relatively stable and mature, this isn’t true for all dividend payers. Investors should evaluate a company’s financial strength and returns potential holistically, and not focus solely on its dividend payments, as some non-dividend-paying stocks may offer better returns than some divided-paying stocks and vice versa.
How do dividends work?
Investors receive dividends after a company decides to pay them. Not all stocks pay dividends to shareholders. Dividend-paying companies tend to be larger, firmly established businesses as opposed to younger or faster-growing businesses. When a company pays dividends, it has less to reinvest in its own business. Because of this tradeoff—rewarding shareholders with dividends vs. investing more in the business in pursuit of higher future earnings growth rates—companies typically shift to paying dividends as their growth rates decline (i.e., there’s less potential reward from reinvesting back in the business.) After a company’s board of directors decides they want to pay dividends, they need to kick off the process of setting deadlines and sharing information. This includes the following milestones:
- Declaration date: The date a company announces key information about a dividend
- Ex-dividend date: The date before which an investor must hold stock to be entitled to the dividend payment
- Record date: The date on which a company determines which investors are entitled to receive a dividend
- Payment date: The date on which the dividend is distributed
Dividends aren’t guaranteed. A company may cut the dividend amount or frequency at any time or cancel them altogether.
Types of dividends
There are a few different kinds of dividends, which affect payment cadence and how they’re taxed.
Payment consistency
Regular dividends
These are paid on a consistent schedule—most commonly on a quarterly basis, though annual and monthly payouts are possible.
Special dividends
These are generally a one-time payment to shareholders. They could be in addition to a company’s regular dividends or issued by a company that doesn’t pay regular dividends at all. Special dividends are usually tied to a particular event or higher than expected earnings.
Preferred dividends
These are paid to investors who own shares of a company’s preferred stock, which are hybrid securities that can offer predictable income and lower volatility like bonds but are typically higher yielding than bonds of the same companies. These payments tend to be fixed amounts, instead of fluctuating as dividends of common stocks do. Dividend payments to preferred stockholders take precedence over payments to common stockholders.
How are dividends paid?
Dividends can be paid in cash or in stock. Cash dividends are paid directly to shareholders. This payment can be deposited directly into a shareholder’s brokerage account, at which point it can be withdrawn, reinvested in the company, or invested in a new asset. It could also be mailed to the shareholder as a check or direct-deposited to an account the investor designates. Or, if you’re enrolled in a dividend reinvestment plan (DRIP), the dividend will automatically go toward purchasing additional shares (or fractional shares, if the dividend amount isn’t enough for a full share) of company stock.
There are also straight-up stock dividends, for which the investor receives additional shares of company stock in lieu of a cash payment.
When are dividends paid?
Regular dividends are commonly paid to shareholders on a quarterly basis. However, some companies may pay dividends annually, semi-annually, or even monthly. Special dividends aren’t paid out on a set schedule but may be paid out when the company has higher than expected earnings or a special event.
How are dividends taxed?
Dividends are taxed only when held in taxable brokerage accounts, not in tax-advantaged accounts, like retirement accounts. When they are taxed, they’re considered either ordinary or qualified. An ordinary dividend is taxed at an investor’s ordinary income tax rate. Qualified dividends, on the other hand, are taxed at your capital gains tax rate, which is typically lower than your ordinary income tax rate. Depending on your income, that rate is 0%, 15%, or 20% at the federal level.
For a dividend to be qualified, you must hold shares in the company for the following specified periods of time before receiving the payment without hedging the investment.
- Common shares: at least 61 days within a 121-day period, starting 60 days before the ex-dividend date
- Preferred shares: at least 91 days within a 181-day period, starting 90 days before the ex-dividend date
- Mutual funds: The fund must meet either of the above requirements for the specific underlying security, and you must have held your applicable share(s) of the fund for at least 61 days within a 121-day period, starting 60 days before the fund’s ex-dividend date.
What is dividend yield and how is it calculated?
Dividend yield is a metric that investors can use to understand how much return on investment they might expect from a dividend-paying stock.
To calculate a stock’s dividend yield:
- Take the stock’s most recent dividend and turn it into an annual figure (for example, multiplying by 4 for a company that pays a quarterly dividend)
- Divide that number by the stock’s current share price
For example, suppose a company with a current share price of $12 pays a quarterly dividend of $0.15 per share. To get the dividend yield, multiply 0.15 (the dividend) by 4 (the number of payments throughout the year) and divide that number (0.6) by 12 (the current share price). Using this formula, you’d see that the company’s dividend yield is 5%. Whether that is considered a high yield is subjective and depends on various factors, including the dividend yield on other stocks and the level of interest rates.
How to evaluate dividend-paying stocks
In choosing a dividend stock to invest in, consider the following information.
1. Dividend yield: Again, this is an estimate of the annual return an investor might earn, just from the dividend, by investing in a given dividend-paying stock (assuming that the stock continues to pay its dividend). Fidelity’s stock screener, which lets you choose dividend yield as a criterion, lists stocks with no yield, very low, low, medium, high, and very high yields. The exact yield percentages can change at any time, depending on market conditions.
2. Dividend history: Does the company have a track record of paying dividends on a regular schedule, or have dividends been sporadic or nonexistent? Has the company paused its dividend program in the past? Dividend pauses or cuts could indicate financial challenges. On the flip side, a long history of consistent dividend payments could indicate financial stability.
3. Dividend growth rate: How has the company’s dividend yield changed over time, in both the short and long term? Has any growth kept pace with inflation?
4. Dividend payout ratio: This is how much of a company’s earnings it pays to shareholders. Less-established companies might prioritize reinvesting cash into the business to grow, while more-established companies may be less focused on growth. In general, the lower this number, the more sustainable a company’s dividend might be. Is the company’s dividend well-covered by the earnings, or do payouts seem unsustainable?
5. Non-dividend-related factors: When considering any investment, it is important to evaluate it from all angles. Dividends, while important, remain just one element to consider when choosing an investment. Some other things to keep in mind before making an investment decision include: the company’s financial health, industry trends, and economic trends, in addition to your personal situation (financial goals, time horizon, and risk tolerance).
What should you do with dividends?
What you do with dividends depends on your investment goals. If your goal for dividend investing is to generate income without selling stocks from your portfolio, then you can put some or all of your dividend payments toward expenses. If you’re investing for long-term growth instead, it may make sense to put the dividends to work in the market. You can do this by reinvesting them in the same company stock or by purchasing shares of a different company (or even different asset class) to diversify your portfolio.
How to invest in dividend-paying stocks and funds
If you’re interested in investing in dividend stocks, you could purchase shares of the following in a brokerage account or other investment account.
- An individual company’s stock: This requires an understanding of how to evaluate stocks and build a diversified portfolio.
- A dividend fund: Certain mutual funds and exchange-traded funds (ETFs) are built around a dividend strategy. A high dividend yield fund, for example, invests in companies offering a higher-than-average dividend yield, while a dividend growth fund invests in companies with a track record of growing their dividend payment. Be mindful of fees, which can add up and eat into your return.
- A separately managed account (SMA): This is a professionally managed portfolio of individual securities. Dividend-focused SMAs seek to provide long-term growth and dividend income while some also look to boost after-tax returns in taxable accounts. Keep in mind that dividends in non-retirement accounts are generally taxable.