What are dividends and how do they work?
Updated: September 06, 2024
Dividend investing allows individuals to generate cash flow from their assets without much work. You don’t have to manage a rental portfolio or make regular enhancements to an existing business. Instead of doing that, dividend investors just have to buy shares in publicly traded corporations that pay out dividends. Investors can also receive dividends from bonds, mutual funds and other assets. This guide will explore what dividends are and how they work.
What are dividends?
Dividends are cash distributions that companies disperse among their shareholders. Many dividend-paying corporations initiate quarterly cash distributions, but investors can also find bonds that give out monthly or annual dividend payments.
Companies draw from their retained earnings to award investors with cash distributions. Dividends encourage investors to stick around, and some people only buy stocks that provide regular cash flow for their investors. This investing model allows shareholders to receive cash without having to sell their shares.
Example of a dividend
Procter & Gamble has been giving out dividends for 134 consecutive years1, and that includes 68 years of consecutive dividend hikes. The company recently announced a quarterly dividend of $1.0065 per share for its investors. A P&G stock investor who owns 1,000 shares will receive a $1,006.50 dividend payout when the company distributes dividends. Owning more shares results in a higher dividend.
How do dividends work?
Every dividend payment goes through three cycles. First, a company declares the dividend so investors know how much they will receive for each share. It’s possible to buy additional shares shortly after the declaration and still qualify for the dividend.
However, you must buy shares before the ex-dividend date. This date represents the deadline for buying shares and still qualifying for the dividend. Finally, you will receive your dividend on the payment date.
Walmart is one of the many publicly traded corporations that follows this model. The company announced a quarterly dividend of $0.2075 per share on February 20, 20242. This dividend had an ex-dividend date of March 14, 2024. Investors who bought shares on March 13 or earlier received the dividend, but investors who bought shares on or after March 14 did not receive that quarter’s dividend.
Why do companies pay dividends?
Companies pay dividends to reward shareholders, build trust and keep their investors happy. A rising dividend is a sign of a healthy company that is growing its revenue and earnings. Some investors hold onto their shares for many years and regularly reinvest dividends to increase their cash flow.
While investors will stick around if dividends continue to arrive, those same investors are likely to abandon ship if a corporation cuts or suspends its dividend payments. AT&T cut its dividend by almost half in February 20223, prompting the stock to drop by 4% on the same day.
A dividend cut may indicate that revenue and net income are declining. It can also demonstrate that a company has run out of meaningful growth opportunities. Regular cash distributions and annual dividend hikes make buy-and-hold investors feel more comfortable with their stock positions.
How are dividends paid?
Dividends are paid out as cash or additional shares. You can adjust the settings in your brokerage account to determine how you will receive compensation for holding onto your shares.
Receiving additional shares gives you more exposure to the business and will increase future cash distributions. However, it’s not bad to receive cash either. Some investors prefer to take the cash and allocate it toward other positions in their portfolio rather than putting all of their eggs in one basket. Some private companies distribute their dividends as checks or ACH transfers.
Types of dividends
These are some of the types of dividends you can use to generate more cash flow.
1. Stock dividends
Some publicly traded corporations distribute dividends to their investors. These payments typically arrive quarterly and are the same throughout the fiscal year. Many corporations raise their dividends each year. These payouts will arrive in your brokerage account, and you can choose to receive cash or reinvest the dividend into additional shares.
Cintas pays out dividends every March, June, September and December4. The company recently hiked its quarterly dividend from $1.35 per share to $1.56 per share, representing a healthy 15.6% year-over-year increase.
2. Variable dividends
Corporations and funds with variable dividends strive to pay out cash distributions on a consistent schedule. However, the cash distribution’s value fluctuates each quarter. While corporations and funds strive to maintain a positive growth rate, they don’t offer fixed amounts.
The Vanguard Growth Index Fund Admiral Shares have outperformed the S&P 500 and Nasdaq Composite year-to-date. This tech-heavy fund initiates quarterly cash distributions that vary based on the fund’s performance. For instance, eligible investors received $0.2299 per share on June 28, 2024. However, eligible investors received $0.2365 per share on March 22, 2024.
3. Mutual funds dividends
Many mutual funds, including VIGAX, pay out dividends to their investors. The dividend payments from these funds depend on their overall performance and the dividend distributions from their holdings. That’s why many mutual funds have variable dividend distributions.
Many mutual funds have a quarterly distribution schedule. You can check a mutual fund’s yield by reviewing its 30-day SEC yield. VIGAX had a 0.43% 30-day SEC yield as of July 31, 20245.
4. Regular dividends
Regular dividends are the quarterly payouts that investors have come to expect. These payouts have been regular occurrences for many years during good and bad economic cycles. Costco has held firm with quarterly dividend payouts for many years. The wholesale giant pays dividends in February, May, August and November6.
5. Cash dividends
Cash dividends are when an investor receives distributions as cash. For instance, Costco offers a quarterly dividend of $1.16 per share. If an investor opts for a cash dividend from 100 Costco shares, that investor will receive $116 in dividends. The investor can increase their cash dividends by accumulating more shares.
6. Property dividends
A property dividend is a distribution that involves a physical asset like property or gold instead of cash or shares in a company. These dividends involve the transfer of ownership of property and other assets.
7. Special dividends
A special dividend is a bonus payout that investors should not expect each year, and Costco’s dividend history is filled with them. Although Costco has established four regular dividend payouts each year, the company announces a special dividend every few years. Costco’s latest special dividend was $15.00 per share. It was distributed to investors on January 12, 2024.
Corporations are not required to issue special dividends. While Costco tends to give out a special dividend every few years, other corporations announce special dividends once and never give them out again. Special dividends do not disrupt regular dividends.
8. Bond dividends
Bond dividends are when an investor receives a bond as a dividend distribution instead of cash or shares. Some corporations issue bond dividends that can be redeemed for cash at a later date instead of giving out traditional dividends.
What are qualified dividends?
Qualified dividends are distributions from corporations that are eligible for more favorable tax treatment. These dividends are taxed at your capital gains tax rate, which cannot exceed 20%. Meanwhile, non-qualified dividends are taxed as ordinary income, which puts those cash distributions in a higher tax bracket.
Most publicly traded corporations distribute qualified dividends. However, real estate investment trusts (REITs) and Business Development Companies (BDCs) are notable exceptions that only provide non-qualified dividends. Stocks with non-qualified dividends tend to have higher yields than average. For instance, Main Street Capital7 is a BDC with a 5.92% yield while Realty Income8 is a REIT with a 5.17% yield.
Dividend dates worth noting and why
Dividend investors pay attention to several dates surrounding distributions. Knowing these dates can ensure that investors receive cash flow instead of barely missing out by a few days.
While it can seem complicated to stay on top of multiple dates, some of them are more important than others. Furthermore, the below simplifies the key dates so you know what to look for when buying dividend stocks.
| Dividend dates | What is it? | Why is it important? |
|---|---|---|
| Announcement date | The date the board of directors announces the next dividend payment | Investors know when to anticipate the next payment. They can review past announcements to gauge when future announcements will be made. |
| Ex-dividend date | The cutoff for investors who want to receive the upcoming dividend | Any shares an investor buys on or after the ex-dividend date do not provide the upcoming dividend. Investors must buy before the ex-dividend date to receive the upcoming dividend. |
| Record date | The date the company records its eligible shareholders | This date indicates when a company determines which shareholders will receive dividend payouts. This information is based on who owned shares before the ex-dividend date and is always one business day after the ex-dividend date. |
| Payment date | The day investors receive their dividends | Investors who use dividends to cover living expenses or reinvest their proceeds will receive funds on this day. They can use the money right away or reinvest it. |
How to invest in dividend stocks?
You will have to open a brokerage account to invest in dividend stocks. These firms will request personal information like your ID, Social Security Number and address to create an account.
Investors can choose from many brokerage firms that let them trade assets like stocks, bonds, mutual funds and ETFs. However, you don’t have to go on this path alone. These are some of the top stock brokers to consider.
If you’re an active investor or options trader looking for a way to save money on trades, you may want to check out discount broker tastytrade. The online service has some of the lowest prices around.
Acorns is an investing service and savings tool rolled into one. This microsavings app makes investing almost painless because you're spending only pennies at a time.
Interactive Brokers offers low trading fees and robust trading tools — major assets to day traders and other DIY investors. Lower-volume traders will also appreciate that they can access commission-free trading through the IBKR Lite plan.
Is dividend investing a good strategy?
Dividend investing may be a good strategy, but it's important to consider your financial goals and risk tolerance. Young investors should prioritize stocks with high growth potential since they have more time to ride economic uncertainty.
Dividend investing can still work for young adults if they focus on dividend growth stocks. These assets tend to have lower yields but have a greater chance of outperforming the stock market. Alphabet is a dividend growth stock that offers a low yield but has outperformed the S&P 500 and the Nasdaq Composite over the past five years.
Older individuals often prioritize cash flow and less risky investments. These people may accumulate established corporations with high yields and limited upside or downside. Procter & Gamble hasn’t outperformed the stock market over the past five years, but its essential products give it more insulation during economic slowdowns. Furthermore, the stock has a 2.38% yield9 and has been around for almost 200 years.
Dividend investing can be problematic for young investors who focus on high-yield stocks that have limited upside. It’s important to maximize returns and incur more risk when you are younger to end up with a bigger nest egg.
Dividend investing pros and cons
Dividend investing is an attractive opportunity since shareholders receive passive income from their investments. While investors have to manage their portfolios and decide which asset to buy, it doesn’t require nearly as much effort as managing a real estate portfolio.
However, dividend investing isn’t perfect either. These are some of the pros and cons to consider before loading up your portfolio with dividend stocks.
Pros
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Receive steady cash flow from multiple investments
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Dividend investing doesn’t require as much work as other asset classes
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Some dividend stocks outperform the market, while others reduce the risk of significant losses
Cons
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Dividend distributions get taxed
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Corporations cannot reinvest dividend distributions into their underlying businesses
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High-yield dividend stocks tend to lag the stock market and growth stocks
FAQs
Marc Guberti is a certified personal finance counselor and a freelance writer who resides in Scarsdale, New York. His work has been featured in US News & World Report, Newsweek, InvestorPlace, and other publications.
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