For people that are new to the stock market, investing jargon can be intimidating. Among the topics that can be confusing are dividends. Many wonder what dividends are and how they affect you, the investor.
In short, dividends are always a good thing. After you’ve become a partial owner in a company (in other words, you’ve bought some of their stock), you’re likely to benefit from a little additional income in the form of dividends (which are, simply put, your share of the company’s profits). Read on to learn about the basics of dividends and how they affect you.
Types of Dividends
Dividends can come in all shapes and sizes. Most of the time, you’ll receive them in the form of cash, but not always. Here are the different types of dividends that you could receive as a stockholder:
The majority of dividends are paid in cash. Let’s say you own 100 shares of ABC Company and at the end of the year, ABC Company declares that they are going to pay a $1 dividend per each share of outstanding stock. That’s great for you—because you own 100 shares of their stock, that’s an extra $100 in your pocket free and clear (except for the taxes you’ll need to pay on them, but I’ll get to that later). Ordinary cash dividends are unearned income at its finest.
Another form of dividends is a stock dividend. A stock dividend is just what it sounds like: instead of paying you a dividend in the form of cash, the company you’ve invested in is going to give you shares of their stock as a dividend. For example, let’s say ABC Company decides that they want to declare a 10% stock dividend. This means each shareholder will get one new share for every 10 shares he or she owns. So if you owned 100 shares of stock, you would own 110 shares of ABC Company stock after the stock dividend.
Yet another form of a dividend payment is a payment of property. That’s right; a company that you have invested in can actually give you property as a dividend. It could be something as simple as a book or a computer or something as outlandish as a piece of land or a car. That sounds crazy, and obviously property dividends aren’t common. In fact, if you’re a typical investor, you may never even see a property dividend. But property dividends do occur in smaller companies held by a small number of shareholders.
For instance, if you own 100 shares of stock of a large, publicly traded company, you might own 0.005% of that company’s stock. Not a lot, right? However, for smaller companies that may be privately owned, a wealthy shareholder (owner) could own 50%, 75%, or even 100% of a company’s stock. When you’re ownership percentage starts to increase and the amount of total shareholders starts to decrease, that’s when you might start seeing property dividends.
The Birth of a Dividend
So, where do dividends come from? The answer is pretty simple. Dividends come from a company’s earnings. Earnings are what is left over after a company has taken all of its expenses – selling expense, marketing expense, product expense, salary expense, compensation expense (for those CEOs and directors) – from its total revenue.
After all expenses are taken from revenue, all that’s left is net earnings. Earnings are to be used to pay dividends, to reinvest in the company, or to pay off the company’s outstanding debt.
From that, you can assume that if a company isn’t performing well and doesn’t have earnings at the end of the year, they’re probably not going to pay any dividends. Additionally, companies should pay dividends at some point (if they’re not using earnings to reinvest or pay off debt) because eventually they’re going to get taxed on the earnings that are held for no reason at all. Typically, large, established companies make good investments not because they’re growing at an aggressive clip but because they pay regular healthy dividends.
What Do You Do With Dividends?
So how do dividend payments affect you, the investor?
You can either take dividends or reinvest them. Either way, dividends are income to you, so you unless the dividends result from investments in a tax-advantaged retirement account, you will have to pay taxes on them.
If you receive ordinary dividends, the company that paid the dividends should send you a form 1099-DIV at the end of that tax year. All you’ll have to do is include the amount on the 1099 form (the total amounts of the dividends that were paid to you) and include it in the income section of your 1040 form (line 9a on form 1040).
Yes, you’ll have to pay taxes on any dividends that you received, but for the most part, you’ll get to enjoy the benefit of some extra cash, stock, or property.
So, there you have it: Dividends are nothing to be afraid of when you begin your investing journey. In fact, dividends are your friend and can often be used to measure the financial stability of a company.