What Are Dividends & How Do They Work?

Dividends allow companies to reward their shareholders by sharing their profits. For investors, dividends are a way to make money off stocks even when share prices stagnate. According to a 2021 investors.com article, 385, or 76.2%, of S&P 500 companies pay dividends. Although not all companies choose to pay dividends, they can be an important tool for attracting investors.

What are dividends?

Dividends are portions of a company’s earnings that are paid out to shareholders. A dividend might be distributed to a shareholder via a cash payment or additional stock, and can be given on a consistent basis or as a one-time payment.

3 types of dividends

There are a few different ways companies may pay dividends to their shareholders. The type and amount of dividend a company chooses to pay will depend on its industry, its profits, and its plans for reinvestment.

1. Regular dividends:

   The most common form of dividend a company might pay are regular dividends. Regular dividends are paid regularly, over an agreed-upon schedule. Usually regular dividends are distributed quarterly, but some companies may use a monthly or annual timetable. Companies that choose to pay their shareholders regular dividends are often ones that have predictable profits or are large and well-established enough to afford consistent dividend payments.

2. Variable dividends:

   Like regular dividends, variable dividends are typically paid on a consistent schedule but in varying amounts, depending on the company’s profits during a given payment period. Companies that sell commodities, or basic goods used in commerce like oil and timber, are more likely to pay out variable dividends. ‍

3. Special dividends:

   Unlike regular and variable dividends, special dividends are a one-time payment. This usually happens when a company has taken in more money than it has immediate use to reinvest. Special dividends can be made alone or in addition to a regular or variable dividend. Companies that give their shareholders special dividends usually do so because they’ve had sudden success, such as selling off a major asset.

Examples of dividends

Target, one of the largest retailers in the US and part of the S&P 500 Index, paid its investors a regular dividend of $0.90 per share in the third quarter of 2021. This is a significant $0.22 increase from the previous quarter’s dividends. And while the company has a relatively low dividend yield of 1.4%, Target has maintained or increased its dividend each quarter over the past 50 years.

Some companies offer more special and variable payments. In April 2021, Sixth Street Specialty Lending, a global investment firm, paid a special one-time dividend of $1.25 per share. This was on top of the base quarterly dividend of $0.41 per share, as well as the quarterly variable supplemental dividend of $0.05 per share.

Dividend FAQs

Here’s what investors want to know when investing in companies that pay dividends.

How are dividend amounts determined?

When deciding whether to pay dividends, how often, and how much, companies must balance their desire to attract the best investors and their need to reinvest profits back into the company. Companies that do pay dividends usually decide on a payout ratio, the percent of a company’s earnings that goes to shareholders.

Typically the dividend payout ratio ranges from 35% to 55% of a company’s net earnings. This allows companies to reward their investors while still saving some money to reinvest into the company, which can help grow its stock value. If a company’s payout ratio is too high, it may not be sustainable.

Before announcing the amount of any given dividend, a company will propose a payout for the board of directors to approve.

When are dividends usually paid?

Regular dividends are usually distributed on a quarterly basis, but companies can choose any schedule, such as monthly, semiannually, or annually. No matter the timetable, companies will announce the next pay period’s approved dividend on a specific, agreed-upon date, often referred to as the declaration date. The declaration date is important because it’s the day that the company will not only share how much the next dividend will be but when the dividend will be paid and who is eligible to receive it.

The first of those dates is the record date, which is the latest date an investor can become a shareholder and receive the upcoming dividend. The very next business day is the ex-dividend date, upon which new investors are not qualified to receive the dividend. And finally, there is the payment date, which, as its name indicates, is the day on which the dividend is distributed to shareholders.

What is dividend yield?

Companies that pay dividends are often evaluated based on their dividend yield, which is the ratio of a company’s annual dividend payments to its stock price. For example, if a company pays its investors $2 per share over the course of the year, and a single stock costs $100, that company’s dividend yield is 2%. Although a high dividend yield can be attractive, most companies have dividend yields below 5%. If it’s much higher, that could be an indication that the payout will become unstable for the company over time.

How are dividends taxed?

The income shareholders make from receiving dividends is taxed differently depending on the type of dividend. An ordinary dividend, which is the most common, will be taxed just like regular income, which lands anywhere from 10% to 37%, depending on how much taxpayers make.

On the other hand, a qualified dividend can be taxed as capital gains, which is 0% to 20%, depending on investors’ tax bracket. What are qualified dividends? Dividends paid by US companies, companies in US possession, a foreign company residing in a country that is eligible for benefits under a US tax treaty, or a foreign company with stock that is readily tradable on an established securities market in the US all count as qualified dividends.

Dividend stock held in a tax-advantaged account (including 401(k) plans and Roth IRAs) will not be taxed until it is withdrawn from the account.

How can dividends be incorporated into your retirement saving strategy?

Investing in companies with reliable dividends or a high dividend yield can be part of a retirement saving and income strategy. Dividend payments can function as an income stream for those who are no longer working; while reinvesting those dividends can help those saving for retirement build a larger portfolio of dividend stocks.

The bottom line

Dividends are one of two main ways investors may make money from their stocks (the other being selling stocks at a profit). Whether they’re paid regularly or in special circumstances, dividends may help investors earn passive income while saving for retirement.