What are dividends and how do they work?

A dividend is a share of a company's profit paid out to the people who own its stock, usually in cash and often every 3 months. Funds pass on the dividends of the companies they hold, and you can take the cash or reinvest it to buy more shares.

Dividends come from profits

A company that earns a profit can keep it to grow the business or pay some to shareholders. Many large US companies pay dividends every quarter, while many younger, faster-growing companies pay none.

Funds pass them through

An index fund or ETF collects dividends from every company it holds and pays them out to you, usually every quarter or every month, minus the fund's costs.

The price adjusts on the ex-dividend date

To get a dividend, you must own the shares before the ex-dividend date. On that date, the share price may fall by about the dividend, because that cash is leaving the company.

Qualified dividends get lower tax rates

In a taxable account, ordinary dividends are taxed like your paycheck. Qualified dividends, which meet IRS holding rules, are taxed at the lower long-term capital gains rates of 0%, 15% or 20%, depending on income.

How a dividend works

A company's board of directors decides whether to pay a dividend and how much, usually stated as an amount per share, such as $0.40. It also sets a record date, the day you must be on the books as an owner to get paid.

The ex-dividend date is usually the record date. If you buy on or after the ex-dividend date, the seller gets that payment instead of you. A few weeks later, the cash lands in your brokerage account, or buys more shares if you reinvest.

How to read dividend yield

Dividend yield is the yearly dividend per share divided by the share price. A fund paying $1.60 a year on an $80 share has a yield of $1.60 ÷ $80 = 2%. Yields change every day because prices change.

A very high yield is not automatically good. A yield can jump because the share price fell sharply, often because investors expect trouble. If the company then cuts its dividend, you lose income and price at the same time.

Why dividends are not extra money

When a company pays a dividend, cash leaves the company and lands with you, so the company is worth a little less. That is why a share price may drop by about the dividend amount on the ex-dividend date.

So a dividend moves value from the share into your account. It is still useful, especially for people living off their investments. But a company that pays no dividend and reinvests its profits can grow its share price instead. What matters is total return: the change in price plus the dividends you received.

Reinvest or take the cash

If you are building savings for the long term, reinvesting is usually the simplest choice. Each dividend buys more shares, those shares pay their own dividends, and the effect compounds over many years.

Taking the cash makes sense if you are retired and living on the income, or if you want to use dividends to rebalance by buying whatever is under target. Either way, the tax in a taxable account is the same, because reinvested dividends are still taxed in the year you get them.

How dividends are taxed

Inside a 401(k), traditional IRA or Roth IRA, dividends are not taxed when they are paid. In a regular brokerage account, they are taxed each year.

The IRS splits them in two. Ordinary dividends are taxed at your regular income tax rate. Qualified dividends, generally from US companies and certain foreign ones held long enough, are taxed at the lower capital gains rates. Your Form 1099-DIV shows both amounts, and the payer is responsible for labeling them.