When a company makes a profit, it often distributes some of its earnings to shareholders. Usually this happens when you own stock in a company, but it can occur in other circumstances as well. These payments are called dividends.
A dividend is a small reward you get for investing in a business, usually through the purchase of stocks. While the payout is generally small on a per share basis, it is still an attractive incentive to invest in a specific company or product, and it can provide a stable, growing income stream over time. When a company announces a dividend, some of its profits are split up and distributed among all the shareholders. Typically, this is done quarterly, but it can be done monthly or yearly as well. Dividends can be paid out as cash or issued as additional shares.
Many companies do not pay dividends, especially if they are trying to grow. Those that do must decide how much of their profits to reinvest in the company (called retained earnings) and how much to distribute as dividends. It’s a balancing act, as reinvested profits may further increase the stock price in the long run, which could be better for your investment than a small payout now. The amount and time frame of dividend payments is usually determined by the company’s board of directors.
The dividend yield (or stock yield) is just another way of comparing a dividend with a company’s stock price. It’s the amount of the dividend earnings received, shown as a percentage of the share price. It is usually between 1% and 5%. For example, if a company has a share price of $100 and it declares a dividend of $5, then the dividend yield will be 5%.
If you’re considering pursuing investments that pay dividends, you may be wondering if dividend income is taxable. Usually, yes, it is. Most of the time, any dividends paid count as ordinary income in the year they are received. There are exceptions, however. Dividends that the IRS classifies as qualified will be taxed at the capital gains rate, which is generally more beneficial. You’ll usually get a 1099-DIV from your brokerage account that outlines any dividends you have received and how they are taxed. For more details, speak with your tax advisor.
Ordinary dividends are what we’ve been discussing so far: money or stock paid back to shareholders. Preferred dividends are a special type of disbursement that returns preferred stocks in the company, rather than cash or common stocks. Generally, preferred stocks offer more dividends, but they do not come with voting rights in the company. (This usually isn’t important to individual investors.) Preferred dividends and stocks combine some of the principal attributes of stocks and bonds and can help generate a steady dividend income stream.
Most people think only of stocks when dividends are discussed. While stocks are probably the most common vehicle in which dividends are awarded, there are other financial products that can give you similar returns on your investment.
Other types of investments that are based on securities and the stock market also pay dividends. Mutual funds and ETFs (exchange-traded funds) are smart ways to diversify your portfolio1 and still reap the benefits of any potential dividends. Some specific funds even focus on maximizing short-term return through dividends.
Other financial products can pay dividends as well. Certain types of life insurance, including some offered by New York Life, can provide dividends that can be used to lower your out-of-pocket cost or give you the option to reinvest into your policy to grow the cash value and increase the death benefit. See how whole life insurance can help you better prepare for the future.
An annuity is an insurance product that allows you to build or convert some of your retirement savings into a stream of guaranteed income payments that last for life, much like a pension. There are two categories of annuities: fixed and variable. Some can earn dividends. Immediate annuities can provide income now if you’re near retirement; deferred annuities are used to plan for income later in life.
With a well-planned strategy and the right mix of investments and products, it is possible to create passive income that can support you in retirement through dividends. However, experts are split on whether this is the most effective way to invest your money. It may make more sense for some than for others.
The consensus is that it makes more sense to focus on dividend-paying funds as you get closer to retirement. When you are investing earlier in life, the funds that invest primarily in the companies that reinvest much of their profits back into their businesses may outperform the funds that invests in companies that pay dividends. Once you are near retirement, however, having a steady stream of income without having to sell off your assets generally makes good financial sense.
Finding the right strategy that balances growth, risk, and reward takes considerable preparation and research. You can go it alone, but having another opinion, especially from a trusted professional, never hurts. If you’d like to learn more and discuss your priorities, please reach out and speak with a financial services professional.