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What Are Dividends?

Dividends are when a company distributes a portion of its profits to its shareholders. Learn more about what they are and how they work here.

Whenever you invest in a stock, you’re buying a small piece of a company. And, when a company begins to profit, it’ll often pass the wealth down to its shareholders (that’s you!) through dividends. These come in the form of cash payments that are commensurate with how much you own of a given firm.

This article will explain what dividends are and how they work. You’ll learn about the types of companies that pay them, as well as how you’ll receive payments. We’ll also zoom out and look at where dividend stocks fit into your overall investment strategy.

What Are Dividends?

Dividends are distributions of a firm’s profits to its shareholders. Typically, companies pay these out with cash or by allocating more shares to investors by reinvesting. Most often, these are distributed quarterly.

When a company turns a profit, its board of directors decides whether to reinvest back into the business or distribute funds to shareholders as dividends. For this reason, not all stocks end up paying dividends.

As a shareholder, you’ll typically own either common or preferred stock. These affect your rights as an owner of the company. The former allows you to receive dividends and vote on corporate policy, as well as the board of director seats. On the other hand, the latter grants you additional features, including receiving dividends at a set rate, as well as priority over common stockholders.

The dividend yield is also an important concept to understand. Matt Hylland, a financial planner at Arnold and Mote Wealth Management, explains it as “the percent of your current investment that is paid to you annually.” He continues, “While this seems simple, dividend yield can be calculated differently,” therefore, it’s important to pay close attention to the method a firm uses. For instance, some may be “based on the prior 12 months of dividends,” while others “may be calculated assuming the most recent dividend continues on for the next year.”

Companies That Pay Dividends

As mentioned above, not all companies pay dividends to their shareholders. Distributions come out of a firm’s profits, which means it reinvests less back into the business. For this reason, it’s more typical for larger companies to follow this practice than smaller ones that need additional funds to scale. As an example, Morningstar listed the following dividend-paying stocks as its top ten in 2024:

  1. Exxon Mobile (XOM)
  2. Verizon Communications (VZ)
  3. Philip Morris International (PM)
  4. PepsiCo (PEP)
  5. Altria Group (MO)
  6. Bristol-Myers Squibb (BMY)
  7. Medtronic (MDT)
  8. Gilead Sciences (GILD)
  9. Duke Energy (DUK)
  10. Pioneer Natural Resources (PXD)

Much like a typical stock, real estate investment trusts (REITs) are another type of taxable corporation you may invest in. However, unlike their counterparts, REITs must pay dividends to their shareholders. These are often available in most brokerage accounts, as well as some retirement vehicles, such as individual retirement accounts (IRAs).

Why Companies Pay Shareholders

Now, you may be wondering why a company would pay out dividends rather than reinvest funds to accelerate growth. Dividends act as an incentive for investors. If a company is sharing the wealth regularly with its shareholders, investors may be more likely to buy shares and retain them. Matt Willer, Managing Director at Phoenix Capital Markets, LLC, similarly points out that companies pay dividends as a “way to return excess profits to share with stakeholders and encourage long-term investment from prospective and existing investors.”

Additionally, a company’s willingness to pay dividends can display its confidence in the business moving forward. It’s quite the undertaking to carve out a piece of the profits to distribute to shareholders. For this reason, a firm has typically matured and has a very positive outlook on its future before it commits to doing so, especially if it guarantees payments.

How Dividends Are Paid Out

Most often, you’ll find firms paying out quarterly dividends in cash. However, not all companies do it this way. Some vary in the means they pay and the frequency with which they do so.

First, be aware that, occasionally, firms may pay you through alternative means than just cash. For instance, one may offer you additional shares instead. Or it may allow you to reinvest back into the company’s stock via a dividend reinvestment program (DRIP). DRIPs let you buy more shares at no additional charge. These allow you to grow your stake in the company if you plan on holding for the long term.

The frequency with which companies pay dividends can also vary. As mentioned, the typical timeframe is quarterly; however, some may opt to pay you monthly or annually. Either way, a firm must set a declaration date, which establishes when it will pay shareholders.

Companies also typically set an ex-dividend date, which acts as a cut-off that dictates if an investor is eligible for a payment. Anyone who buys shares after this won’t be able to receive dividends. To be eligible, you must have bought before the record date, which typically occurs one business day after the ex-dividend date.

Paying Taxes on Dividends

Earnings from dividend payments count as taxable income. However, their tax rate can differ depending on whether they’re qualified or not.  For a dividend to be qualified, it must typically be from common stock that you’ve held for at least 60 days. All others are non-qualified.

Qualified dividends incur a capital gains tax rate of 0%, 15%, or 20%. What you’ll need to pay is largely dependent on your total income. Non-qualified payments, on the other hand, are treated as ordinary income for tax purposes.

You should also be aware that your state may require you to pay either income or capital gains tax on dividend payments. This tax rate differs depending on the state you live in. These are the only states that don’t charge a capital gains tax:

  • Alaska
  • Florida
  • New Hampshire
  • Nevada
  • South Dakota
  • Tennessee
  • Texas
  • Wyoming

While dividends do require to pay taxes, Hylland points out that qualified dividends are taxed at a rate that’s “very favorable” when one compares it to “interest.” He adds, “While interest (received from a bond or CD for example) is taxed at income tax rates, qualified dividends are taxed at long term capital gains tax rates. This is 15% for most investors, but there is a window where married households with under $94,000 in taxable income can have qualified dividends taxed at 0%.”

Where Dividend Stocks Fit into One’s Investment Strategy

Dividend stocks are a common way that investors can add passive income to their portfolios. For this reason, they can be quite enticing, especially to beginners. However, before jumping in, you should be sure that investing in such securities aligns with your goals.

Hylland, a financial planner, warns that simply selecting “an investment based solely on dividend yield is very dangerous.” This is because a “high dividend yield can also be a sign of a very risky investment.” Additionally, he warns you not to “risk losing 50% of your investment for a 7% dividend yield.”

Per Hylland, you should also understand that “dividends are never guaranteed” and that they “don’t come with the same safety as bond interest, for example.” He adds that “GE and General Motors are great lessons of this” because they “paid high dividends for many decades, but during the 2009 financial crisis they cut their dividends or eliminated them altogether. If your retirement income depended on these dividends, you would have been in significant trouble.” The moral of the story is that you shouldn’t expect these payments to make up your entire income or continue forever because there are always external forces that may affect or remove them altogether.

Despite these warnings, dividends are still an added benefit of investing in certain stocks. It’s not a bad idea to consider them as you invest, especially in the long term. However, as Hylland explains, it may not be wise to base your decisions solely on them due to the risks.

Before investing, we recommend sitting down with a financial advisor, such as an investment manager. To find a high-quality professional near you, you can use this free matching tool. After you fill out a short quiz, it’ll pair you with an expert that suits your needs.

Frequently Asked Questions

Do dividends make you money?

Dividends can earn you income as part of your overall investment strategy. Firms typically pay in cash or with additional stock. However, be aware that your earnings will be subject to either capital gains or ordinary taxes.

How often are dividends paid?

Dividends commonly pay every quarter. Some, though, may do so monthly or annually. Pay close attention to the declaration date, which establishes the timeframe in which you’ll receive payments.

Can I live off of dividends?

While it may be theoretically possible to live off of dividend income, provided you make enough, it’s a risky path. As Hylland breaks down earlier, payments aren’t always a guarantee, and some companies may choose to eliminate them if they fall on hard times. Because you don’t necessarily control your destiny, it may not be wise to rely exclusively on dividend payments. We recommend speaking with a financial advisor to create a retirement plan that aligns with your goals before committing to a strategy.