What are dividends?

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 dividend payouts.

What is the definition of dividends, and how do they work?

Dividends are a type of payment you receive from a company in return for being a shareholder (or policy owner, in our case). These payments, which can be taken in cash or reinvested to buy more shares, are usually distributed whenever a company turns a profit. Of course, it’s important to know that dividends—like profits—are not guaranteed. 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 can increase the stock price in the long run, which could be better for your investment than a small payout now.

How much money can you make from dividends?

The amount of money you receive from dividends depends on a variety of factors, with one of the most important being the total number of shares you own. Since the payout you receive is on a per-share basis, people who own 100 shares of a stock can count on getting twice as much money as those who have 50.

What is a dividend yield and how is it calculated?

The dividend yield (or stock yield) is a 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 current share price of $100 and it declares a dividend of $5 per share, then the dividend yield will be 5%.

What are ordinary and preferred dividends?

Ordinary dividends are what we’ve been discussing so far: money or stock paid back to shareholders. Preferred dividends are a special type of payment that you get when investing in preferred stocks. These payments are often fixed (ordinary dividends can fluctuate), so they operate more like a bond. What’s more, preferred dividends are usually given a higher priority if the company becomes insolvent, so they are generally considered to be more secure.

Which investments and products pay dividends?

You may be surprised to find that there are many ways for people to capitalize on dividends. We’ll start with the most familiar ones, and then introduce a few that you may not have considered.

Dividend stocks

When you think about dividends, and where to find them, there’s a good chance that stocks are the first thing that come to mind. While not all stocks generate a dividend, many do—and it can be an important factor to consider before deciding to invest. To find out if a stock pays a dividend, you can search financial websites like Morningstar or Dividend.com, work with a financial professional, or visit the company website and look for information about their dividend yield.

Mutual funds and ETF dividends

Since stocks are a common place to search for dividends, it only makes sense that they would be included in mutual funds and exchange-traded funds (ETFs). In fact, there are many funds that invest solely on various dividend-earning stocks, so it can be an easy and effective way to diversify your holdings and invest in multiple companies at once.¹

Life insurance

You may be surprised to hear that certain types of life insurance from a mutual insurer, including some offered by New York Life, are also eligible to earn dividends. These dividends are completely different from the stock dividends. Life insurance dividends are distributed from the insurer’s surplus and only eligible policyholders of participating policies can receive them. While these dividends are not guaranteed, New York Life realizes how important they are to our whole life policy owners, and has paid them consistently throughout our long history. When dividends are declared, you have four options:

1. Take them in cash
2. Use them to pay premiums and reduce your out-of-pocket costs
3.  Leave them on deposit to earn interest
4. Use them to purchase additional coverage (the most popular option)

Annuities

An annuity is an insurance product that allows you to turn some of your retirement savings into a stream of guaranteed income payments—much like a pension. Here again, you may be surprised to learn that some annuities from a mutual insurer may earn dividends. If this feature is important to you, a New York Life financial professional will be happy to guide you to the right products and answer any questions you may have.

Do you claim dividends on taxes?

If you’re considering investments that pay dividends, you may be wondering if dividend income is taxable. In most cases, the answer is yes, but there are exceptions (as you’ll see below).

What is the tax rate on dividends?

Any dividends you receive will be taxed as ordinary income on your federal (and state, if applicable) return. There are exceptions, however. Dividends that the IRS classifies as qualified will be taxed at the capital gains rate, which is usually more favorable. For dividends to be qualified, you must own the stock for at least 60 days (common stock), or 90 days (preferred stock). What’s more the dividend must be paid by a U.S. corporation, or one with specific ties to the U.S.² Fortunately, you should 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.

Do you pay taxes on dividends that are reinvested?

Reinvesting dividends can be a sound strategy for anyone who is trying to build up their portfolio. Even though you are using your dividends to purchase more shares (rather than receive the cash), the IRS considers it a form of income, so it is usually taxable.

Are life insurance dividends taxable?

In most cases, life insurance dividends are considered a return of premiums and are not taxable. The only time that dividends would be taxable is if the policy is overfunded and becomes a Modified Endowment Contract (MEC).³ Even then, the only time that dividends would be taxable is if they are taken as cash. If dividends are put back into the policy, it does not count as a “taxable event.”

Is it possible to make passive income with dividends?

With the right mix of products and investments, it is possible to use dividends to create a passive income stream. However, experts are split on whether this is the most effective way to invest your money or if it is better to focus on growth instead. A financial professional can help you explore both options and see which makes the most sense for your particular needs.

When should you start focusing on dividends?

While dividends are always helpful, many financial professionals believe it’s better to focus on growth stocks when you are younger and switch to more conservative dividend stocks as you approach retirement. That way, you’ll be able to create a steady stream of income without having to sell off your assets—which can be a good wealth preservation strategy.

Choosing the right financial vehicles for dividends

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.

How ofter are dividends paid?

When a company declares dividends, they are usually distributed quarterly, bi-annually or annually. That’s why so many seniors use dividends as a recurring source of income in retirement.

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 ¹Diversification does not assure a profit or protect against market loss.

²IRS Publication 550, “Investment Income and Expenses,” https://www.irs.gov/pub/irs-pdf/p550.pdf

³Certain tax advantages are no longer applicable to a life insurance policy if too much money is put into the policy during its first seven years, or during the 7-year period after a "material change" to the policy. If the cumulative premiums paid during the applicable 7-year period at any time exceed the limits imposed under the Internal Revenue Code the policy becomes a “Modified Endowment Contract” or MEC. A MEC is still a life insurance policy, and death benefits continue to be tax free, but any time you take a withdrawal from a MEC (including a policy loan), the withdrawal is treated as taxable income to the extent there is gain in the policy. In addition, if you are under 59 ½, a penalty tax of 10% could be assessed on those amounts and upon surrender of the policy.

Note, all investments involve risk, including loss of principal. Investments are offered through NYLIFE Securities LLC (member FINRA/SIPC), a Licensed Insurance Agency and a New York Life Company.

Neither New York Life nor its agents provide tax, legal, or financial accounting advice. Please consult your own tax, legal, or accounting professional before making any decisions.