One of the best things about investing in highly-profitable blue chip stocks is these companies have no shortage of capital to return to shareholders. This capital comes in the form of dividends – small payments given to investors for each share of company stock they hold. Investors get a dividend payment for each share they own, usually distributed quarterly. Dividends can go right back into your brokerage account, or be reinvested back into the paying firm.
Dividends are usually paid by older, more established companies. Young companies seeking growth often have expansion goals and debt obligations to meet, so paying dividends is counterproductive. Dividends can be a big boost to your portfolio, but there are certain considerations all investors need to be aware of – especially when it comes to taxes.
How Are Dividends Calculated?
Dividends are earnings paid to investors when companies have no internal use for the extra capital. Big tech firms like Amazon and Google don’t pay dividends because so much of their extra cash is plowed back into research or new expansions. But less growth-obsessed companies like banks, consumer goods producers, and utilities often return their excess profits to shareholders. Dividend payments are determined by the dividend yield, which divides the dividend payment by the company’s share price to form a percentage.
For example, Duke Energy (DUKE) currently has a 5.53% dividend yield. With a share price of $68.33, that means a $3.78 annual dividend, or about 95 cents each quarter. How often are dividends paid? Most firms pay a quarterly dividend, but some also do biannual or annual payments. Note that the dividend yield represents a full year of payments, so don’t expect to be paid a 5% dividend each quarter.
Stock dividends are calculated through a combination of long-term profit forecasting, current sector trends, business plan assessment, and balance sheet stability. When calculating how much of a dividend to pay, these are some of the questions companies ask themselves:
- Is the company projecting consistent long-term sales growth?
- How much more expansion suits the business model?
- How much debt has been accumulated?
- What is the yield paid from other firms in the sector?
Paying too high of a dividend might leave a company short on cash in a crisis, but too low a dividend might cause investors to seek out better paying stocks in the same sector. Calculating a dividend is a balancing act from a business perspective, but most dividend-focused companies seek to steadily increase payments each year.
Dividends aren’t set in stone, either. Companies languishing through poor sales periods could slash their dividend in order to save money and high-yielding dividends should be investigated. Kinder Morgan (KMI) famously cut its dividend by 75% following the accumulation of an unsustainable debt load and the stock price also cratered. If a company has a dividend yield that looks too good to be true, make sure you find out WHY the yield is so high before investing. Some stocks like REITs are legally required to pay out large dividends. Or perhaps the stock has entered a bear market and the high dividend yield doesn’t reflect high profits, but a drastic stock price decline. In general, companies that have raised dividend payments for a decade or more are considered to have “safe” yields.
How Will You Receive Dividend Payments?
To receive a dividend, you must own the stock on a specific day known at the Ex-Dividend Date. If a stock pays a dividend on March 30 with an ex-dividend date of March 12, you must own the shares before March 12 and have held them for at least 2 business days (but no longer than that). Yes, you can buy shares on March 10, sell your shares on March 13, and still receive a dividend for each one on March 30. Does this sound too good to be true when trades are commission-free? Well, it is. More on that when we get to taxation.
If you are eligible to receive a dividend, you’ll be paid on the cleverly-named Dividend Payout Date. In our example above, this date would be March 30. Dividends are disbursed from the paying company to a clearinghouse known as the Depository Trust Company. The Depository Trust Company makes a record of all dividend payouts and distributes them to shareholders through their individual brokerage accounts. The DTC is huge – over $54 trillion in assets and securities are held by the firm. Once the DTC has paid out the declared dividends, shareholders are free to keep them or reinvest them back into the stock.
Do You Have to Pay Taxes on Dividends?
Yes, just like any other investment gain, the IRS wants its cut of your dividends. However, like stock gains, dividends are usually taxed at a much lower rate than income earned from work or interest. But that depends on the classification of the dividend. Not all dividends are created equal and one class has distinct tax advantages over the other.
Most companies pay what’s called a qualified dividend, which means the payment is taxed at the capital gains level, not the income level. Qualified dividends are taxed either 0%, 15%, or 20% depending on your adjusted gross income. If you make less than $39,000 per year, your qualified dividends will likely carry no taxation at all. The 20% capital gains rate only applies to those making more than $434,000 annually.
To be labeled a qualified dividend, the payment must meet two qualifications:
- It must be issued by a US corporation or trade on a US exchange.
- It must be paid toward shares that have been held for at least 60 days.
Remember how it seemed too good to be true to get a dividend for only owning a stock for 2 days? Well, here’s why. If you haven’t held the shares for at least 60 days, your dividend will be classified as an ordinary dividend and you’ll be taxed at the normal income level. How stock dividends are paid matters greatly for taxes purposes, so be sure to understand the criteria for qualified vs ordinary. Selling a stock a day too soon could increase your tax burden by 20%! Dividends are intended to reward long-term shareholders, so jumping from stock to stock in search of dividend yield will be counterproductive.
If you received more than $10 worth of dividends from a single payer in a calendar year, the IRS will expect you to fill out Form 1099-DIV. Both ordinary and qualified dividends are reported on this form, along with capital gains distributions, nondividend distributions, and collectibles gains. And obviously, if you hold dividend-paying stocks in a retirement vehicle like a Roth IRA, you don’t need to worry about any type of taxation. Also, some companies pay dividends simply by issuing additional shares. You won’t be taxed on these shares until they’re sold.
Can You Defer Your Dividend Payments?
Some investors may wish to defer dividend payments in order to avoid paying taxes, but unfortunately dividends cannot be deferred. However, there are a few ways to tiptoe around the tax laws regarding dividends.
Remember, qualified dividends are taxed at the capital gains level. If you fall into one of the two lowest American tax brackets, your qualified dividends will be taxed at 0%. Additionally, tax-sheltered vehicles like IRAs and 401(k) accounts can be used to reduce your tax burden, as can charitable donation of shares. Also, shares bequeathed to heirs after death will be exempt from dividend taxation, provided the investments aren’t great enough to trigger the estate tax.
Reinvesting Your Dividend Payments
Many companies offer a dividend reinvestment program (DRIP). With a DRIP, any dividend paid is automatically used to purchase more shares of the company. This has advantages for both the investor and the paying company.
For the investor, reinvested dividends aren’t subject to commissions or bid/ask spreads since the shares are purchased directly from the company and not on an exchange. Many firms also offer discounted rates on shares when DRIPs are executed and fractional shares can be acquired easily. And of course, reinvesting dividends also means more compound interest at work for the investor’s capital.
For the company, dividend payments are immediately reinvested back into the firm and that capital can be redeployed elsewhere. Shares purchased through DRIPs can only be sold back to the company too. Shares from dividend payments aren’t as liquid as open market shares, so DRIPs are usually only utilized by investors who plan on sticking around for the long-haul. For a publicly-traded company, these are exactly the type of investors you want to attract.
Maximizing Your Dividends
Blue chip stocks might not have the exciting growth prospects of new(er) tech firms like Amazon and Google, but dividend paying stocks can still have a place in your portfolio. Dividend-paying stocks can be safe harbors during periods of market turmoil and provide immediate income to investors’ accounts. Dividend-paying stocks tend to be less volatile since they’re often older, more established companies. Dividends provide consistent quarterly income, regardless of the performance of the overall market. If a stock declares a 6% dividend but then falls 20% before the payment, the dividend will still reflect the share price as the time of the declaration.
However, dividends can also complicate your investment process through taxes. If you hold dividend-paying stocks in a taxable account, make sure you understand how they’re distributed and whether they’re classified as qualified or ordinary. Ordinary dividends are taxed at the income level, which could create a mess on your IRS paperwork in April.
Reinvesting dividends back into the stock is a time-tested strategy for building a nice retirement account. You’ll still be taxed on the amount you receive, but you’ll pay a lower rate, increase your equity stake in the company, and take even greater advantage of compound interest.