Dividend Strategy 101: What Are Dividends & How Do They Work?

Investing can be done to save for retirement or simply to increase your income. Some people invest with both purposes in mind. If you want to make income generation part of your overall investment strategy, then you may want to consider dividend investing as a strategy to try.

At Addition Financial, we often speak to our members about issues related to investing and one of the questions we are asked frequently is this.

What are dividends?

Since understanding how to earn dividends is necessary if you want your investments to be a source of income, we’ve put together this dividend strategy guide. Here’s what you need to know.

What Are Dividends?

Let’s start with the most basic question: what are dividends? Simply stated, a dividend is a redistribution of a company’s profits to its shareholders. In many cases, companies pay dividends on a quarterly basis.

Shareholders may receive dividends either as a cash distribution or as a reinvestment in the company’s stocks. Reinvestment can be a good choice provided that the company in question doesn’t comprise more than 5%-10% of your total portfolio. 

Some investors prefer to take dividends as cash distributions that they use to augment their income from other sources. Dividend investing can be part of an income investing strategy.

Dividends may be paid by individual companies but are also sometimes paid by exchange-traded funds (ETFs), Real Estate Investment Trusts (REITs) and mutual funds.

Types of Dividends

There are three main types of dividends.

#1 Ordinary Dividends

Ordinary dividends are dividends that are paid regularly and are taxed as ordinary income, meaning that they are taxed at the same rate as the income from employment.

#2 Qualified Dividends

Qualified dividends are dividends that are earned on stocks you purchased before the ex-dividend date and hold for 61 days or more. They must be issued by a U.S. corporation or a qualified foreign entity and may not be listed by the IRS as a dividend that does not qualify.  If you have dividends in your portfolio that meet these qualifications, your earnings will be taxed at the lower capital gains tax rate instead of the ordinary tax rate.

#3 Special Dividends

Unlike ordinary dividends, special dividends are non-recurring and typically larger than ordinary dividends. They are most often paid out after a significant event such as a corporate restructuring or an asset sale.

Dividend Terminology

Here are a few terms related to dividend investing that you should know:

  • Dividend yield is expressed as a percentage and is an estimate of the dividend-only return on shares. The dividend yield of an investment rises and falls with the stock price and is typically lowest for new companies and highest for established companies in a period of sustained growth.
  • Ex-dividend date refers to a date when a new investor would be buying the stock without the value of the next dividend. When a company board announces dividends to be paid, that is the record date. On that day, an individual must be listed as a shareholder in the company records to earn the dividends. If someone buys shares ex-dividend, the dividends to be paid will be remitted to the previous owner.
  • Dividends per share refers to the dollar amount paid for each share in the company.

These terms can help you navigate the process of investing in dividend-paying assets.

What Are the Advantages of Investing in Dividends?

There are several important benefits to choosing a dividend investment strategy.

Predictable Returns

Dividend investments tend to be with stable companies that are in a state of sustained growth and aren’t taking big chances that could cause the company’s value to plummet.

The result is that dividend stocks tend to have more predictable returns than other stocks and may therefore be less risky than non-dividend-paying stocks.

Insulation from the Stock Market

Stock market fluctuations are common and may be difficult to predict, particularly for a layperson who’s not dialed into the market news every day. Dividend investments provide some insulation from stock market volatility because dividends offset the initial expenditure to buy stocks.

The longer you collect dividends, the more money you will have earned from your investment. You still hold your shares but you’ll have the benefit of having money in your pocket, too.

Regular Source of Income

It can be nearly impossible to predict what you’ll earn in the long term when you buy shares in a company. That’s not the case if you buy shares in a company that has a solid history of dividend payments.

If generating income is part of your investment strategy, then buying dividend assets can help you earn regular income, typically on a quarterly basis, to supplement what you already earn from your employment and other sources.

Are There Drawbacks to Investing in Stocks That Pay Dividends?

As you might expect, there are a few potential drawbacks to investing in stocks that pay dividends.

Dividends from Common Stocks Are Not Legally Required

There may be a disconnect between company growth and dividend payments. A company may decide to cut its dividend payments at any time and for any reason. 

Dividend cuts are most likely to occur when there’s a cash flow problem that makes it difficult for a company to pay dividends to shareholders.

Lower Overall Earning Potential

While it’s true that dividends can offset the initial cost of purchasing shares in a company, they can also put a cap on your overall gains because they impact the growth potential of the company.

When a company pays out dividends, it also decreases the amount of its profits that it can put toward growth strategies, so that’s something you’ll need to keep in mind.

High-Yield Dividend Traps

Let’s end this section with a warning. Sometimes, a company will pay high dividends in order to attract new investors. The downside is that the high-yield dividend may end up being smoke and mirrors if a company can’t afford to sustain payments at that level.

It’s essential to review a company’s dividend history before buying. You should also be aware that a sudden drop in a company’s share price may herald a reduction in dividends since most companies won’t want to pay a significantly higher dividend as a percentage of stock value.

How Does One Calculate Dividend Yield?

If you want to calculate the dividend  yield of an investment, there’s a simple formula that will allow you to do so.

Dividend Yield = Annual Dividends Per Share/Price Per Share

Here’s an example. Say you owned 100 shares in a company that paid you $5 per share each year. If you paid $110 for each share, your dividend yield would be $5/$110, or 4.545%.

Some investors prefer to take the most recent quarterly dividend and multiply it by four to calculate the annual dividend. This method is accurate if you’ve invested in a company or fund that pays the same amount each time. However, it may not be accurate if dividends have fluctuated or if you’ve invested in a company that pays small quarterly dividends and a larger annual dividend at the end of the year.

You may want to try several methods to determine which is the most accurate for your investments.

How Are Dividends Taxed?

As we mentioned above, dividends may be taxed either as ordinary income or capital gains depending on the type of dividend and how long you’ve held the investment.

If you have held a dividend-paying share for less than 61 days during a 121-day period beginning 60 days before the ex-dividend date, the dividends will be taxed as ordinary income. We recognize that’s confusing, so here’s an example.

A company has an ex-dividend date of April 1st. If you bought the stock on February 1, you would have owned it for only 59 days and it would be considered an ordinary dividend and taxed at the ordinary income tax rate.

If on the other hand you purchased the stock on January 15, you would have owned the stock for 75 days and your dividends would be taxed at the capital gains tax rate.

You should also be aware that there are two capital gains tax rates, one for short-term capital gains and one for long-term capital gains. If you own stock for less than a year and sell it at a gain, it will be taxed at the short-term capital gains rate. If you own it for more than a year and sell it, it will be taxed at the lower long-term rate.

One exception to dividend taxation is if you receive dividends from investments that are part of your retirement account, such as an IRA or a 401(k), since earnings are typically tax-exempt (in the case of a Roth IRA) or tax-deferred (in the case of a traditional IRA or a 401(k) account.)

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Build Your Dividend Investment Portfolio with Help from Addition Financial

Anybody who is interested in buying dividend stock should be sure to understand how dividends work and generate income before taking the plunge. The information we have included here can help you prepare for your first dividend stock purchase.

Are you ready to increase your income by earning dividends? Addition Financial has what you need. Click here to read about our Benefits Checking account and join today!

The content provided here is not legal, tax, accounting, financial or investment advice. Please consult with legal, tax, accounting, financial or investment professionals based on your specific needs or questions you may have. We do not make any guarantees as to accuracy or completeness of this information, do not support any third-party companies, products, or services described here, and take no liability or legal obligations for your use of this information.