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How Do Dividends Work?

So, there’s an old saying, “It pays dividends.” It just means that something you do now can pay off in the future. In the world of stocks, sometimes it actually does—in the form of, well, a dividend. So, what are those? Dividends are regular payments of a company’s profits to shareholders. They’re sort of like rewards for putting your money into their venture.

Most often, companies pay out dividends in cash, but they can also give additional stock to their shareholders as the reward.

So why would a company do that? For one, it’s a way of rewarding their investors for putting their trust—and cash—in the company. But dividends also tend to have a positive effect on an investor’s outlook on the company. If an investor is consistently getting paid good dividends from a company, they’re likely going to be pretty loyal!

Now that you’ve got a little of the why, let’s dive a little deeper into how they work.

How Does a Dividend Work?

Say you buy 10 shares in a company and they announce a $1 dividend per share for this quarter, so you get a $10 dividend payment. If they do this for each quarter throughout the year, you’ll end up with a total dividend of $40 for that year. Pretty simple, right?

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Some companies also offer dividend reinvestment programs, called DRIPs (I know, not a great acronym). These let you reinvest the cash dividend back into the company’s stock—often at a discount. And of course, if the company pays the dividend in new shares of stock instead of cash, it just means you own a little more of that company.

The company’s board of directors makes the call on how the company pays its dividends and how frequently they’re paid out—monthly, quarterly (most common in the U.S.), or annually. The catch is that the board also has to get shareholder approval on the distribution of the dividends through a vote.

Types of Dividends

On top of getting bonus money, a lot of folks like dividends because they can come with some tax advantages. But these advantages depend on the type of dividend you’re dealing with—qualified or unqualified.

  • Qualified: If you’ve owned the stock for more than 60 days before the ex-dividend date (or ex-date)—aka the day that determines your eligibility to receive the dividend—and the dividend was paid by a U.S. company or qualified foreign corporation, that dividend is qualified. Qualified dividends get better tax rates because they’re actually taxed at long-term capital gain rates rather than income tax rates.1
     
  • Unqualified: Also known as ordinary dividends, these dividends are unqualified because you didn’t own the stock for more than 60 days before the ex-date. These dividends are taxed at your regular income tax rate.

Dividends From Other Sources

Now, dividends don’t only come from single stocks. Other investments, and even some insurance companies, also pay dividends. For example, mutual funds contain shares of multiple companies’ stocks, so you’re considered a shareholder and can receive dividends.

In the case of mutual funds, the dividend is based on a fund’s net asset value (NAV) calculation (that’s just a fancy way to say assets minus debts) when the stock market closes. If your shares in the fund earned a profit, the mutual fund company can choose to use that money to reinvest in the company, pay down debt, or give you a cut of the profit in the form of a dividend.

Bonds are another type of investment that can pay dividends. As a refresher—when you buy a bond, you’re lending money to a company or government entity. In exchange for your loan, the company or government agrees to pay you a fixed rate of interest, aka a dividend. Unlike stock dividends, bond dividends are a legal obligation, but I don’t recommend betting your retirement on bonds—you’re better off investing your money in a mix of growth stock mutual funds.

Another vehicle that might pay a dividend is a surprising one—life insurance. Some insurance companies are called mutual insurance companies, because they’re not publicly traded and the policyholders own the company “mutually.” If the company makes a profit, they can declare a policyholder dividend. But remember, people: Life insurance is not an investment—it’s insurance. So, skip the gimmicks here and go for a solid term life insurance plan.

How Do Dividends Affect Stock Prices?

Once the news of a dividend payment becomes public, you can see a rush to purchase the stock before the ex-date. (Have you ever seen the running of the bulls? It’s like that.) In this case, you’ll see the share price go up. Another thing you’ll often see is the price going down after the ex-date because anyone buying the stock on or after that date won’t receive the dividend, so people sell the stock.

Should You Invest in Something for the Dividends?

While dividends might feel like a bonus or reward, it doesn’t make sense to invest in something just for the dividends. That’s like playing football for the shiny helmet.

When you get to the point where you’re investing 15% of your income so you can retire inspired, stick with employer-sponsored plans, like a 401(k) or 403(b), and Roth IRAs with good growth stock mutual funds. And, hey, some of those mutual funds might pay dividends, so you may still get a reward after all! Just look at it as the icing on the cake.

Get With a SmartVestor Pro

Look, there’s a lot to take in when you’re trying to figure out what makes an investment worthwhile, but you can do this! And you don’t have to do it alone. Connect with an investment professional, like one of our SmartVestor Pros, who can walk you through your best options. Our program connects folks with qualified investment professionals who are familiar with what we recommend and can guide you in creating a retirement plan with your goals in mind.

Find a SmartVestor Pro in your area today!

Chris Hogan

About the author

Chris Hogan

Chris Hogan is a two-time #1 national best-selling author, financial expert and host of The Chris Hogan Show. He is a frequent guest on Fox News, Fox Business, Yahoo! Finance and the Rachael Ray Show. Since 2005, Chris has served at Ramsey Solutions, where he gives practical money advice on retirement, investing and building wealth. Learn More.

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