As an investor, one of your biggest goals may be to eventually live off of passive income streams. Contrary to active income — which you earn every time you clock in at work or complete a side hustle project — passive income allows you to grow your wealth without trading any additional hours of your time.
Passive earning can come in many forms, but perhaps one of the most lucrative is through dividends. In fact, many savvy investors find ways to live entirely off of their dividends, earning enough of this “free money” each year that they never even have to touch their investments.
So what exactly are dividends, how can you begin earning them, and what’s the catch?
What are dividends?
If you buy certain investments, you might be pleasantly surprised to receive a dividend payment over the course of your ownership. These payments, also referred to simply as dividends, are essentially your portion of a company’s earnings over a given period of time.
As a shareholder, you are entitled to a dividend payment if the company recognizes a profit and the company’s board of directors approves said dividend payout. Generally, dividends are paid out in regular intervals, though this is contingent on the company’s earnings and dividend policy, as well as each class of its shareholders and how much stock you personally own.
How dividends work
Let’s say that you own stock in a company, and that company recognizes record profits this year. If they approve dividend payouts, you and other shareholders will receive your portion of a company’s profits for that year.
Dividends may be paid as a lump sum annual dividend, or might be paid every few months as quarterly dividends. It really just depends on the company’s dividend policy and how successful they are at the time.
The type of dividend payment you’ll get can also vary. They may come in one of two forms:
- Cash dividends
- Stock dividends
As the name implies, cash dividends are paid out as, well, cash. If you own 500 shares in a specific company, for instance, and the dividend payout in a particular year is $0.30 per share, you would get a cash payment of $150.
Once investors receive the dividend, they can use this money as everyday taxable income, spending it as they would a payment in any other form. This money could also be used to purchase additional shares of stock, which is referred to as dividend investing (or reinvesting in your brokerage account).
Investors may also be paid dividends in the form of stocks. Stock dividends are allocated to shareholders in the same way as cash dividends; the difference is that investors will get additional shares of stock rather than money.
Let’s say that you own the same 500 shares in a specific company as above, but the dividend distribution is being given as 10% shares. At the end of the distribution period, you would own 550 shares in the company: your originally-purchased 500 plus your dividend yield of an additional 50 shares.
Both cash dividends and stock dividends are essentially free money from companies during periods of growth. Either type of dividend can be utilized to build wealth and grow your retirement portfolio, while requiring less out-of-pocket capital from you.
Which types of investments pay dividends?
Not all companies offer dividend payments to investors. In fact, companies that are focusing on foundational growth will often choose to reinvest earnings back into the company instead of distributing anything extra to investors.
Generally, you can expect mutual funds, exchange-traded funds (ETFs), and unit investment trusts to all pass along dividends to investors. Many older, mature companies that are publicly traded will also pay dividends to shareholders when a profit is recognized (these are usually referred to as dividend stocks). Dividend payments from these companies can help to boost investor confidence in the company and even encourage stock sales.
Other investments that may be paying dividends include real estate investment trusts (or REITs) as well as closed-end funds. Private companies are also able to offer dividends payments if they so choose.
Who typically gets dividends?
As mentioned, there are different “levels” of shareholders that can receive dividend payments. The company’s dividend policy, profits earned, and where you fall in that shareholder hierarchy can all determine how much of a distribution you get, or whether you can expect a dividend at all.
Generally, there are two types of shareholders: common and preferred. When a company is deciding how to distribute a dividend (and who gets what), preferred shareholders take priority. There are times when preferred investors are paid dividends while common investors are not, and other times everyone gets a share in the profits.
Sometimes, companies will pay out what’s called a special dividend. Special dividends are usually one-off cash payments, and are not recurring the way that quarterly or annual dividends are. Special dividends may be given to all shareholders, or only to specific levels of shareholders within the company.
Dividend payments aren’t guaranteed
There are many reasons why a company wouldn’t pay dividends in a given year (or quarter), from experiencing a financial loss to restructuring. Even if you have gotten dividend distributions religiously, it’s important to remember that they are never guaranteed: a company’s board of directors can choose to eliminate your dividend payout at any time.
If a company decides to cut or pause dividend payments, they can do so without warning. They can also choose to allocate dividends based on hierarchy, or each class of its shareholders. Bondholders are generally first in line (and get a higher percentage of dividends), followed by preferred shareholders and then, if anything is left, common shareholders.
How dividend payments can transform your investments
If you own dividend stocks, you have an opportunity to boost your investments — and overall financial situation — regardless of where you are in your investing journey.
As a young investor, you have the advantage of time in the market. This means that you can afford to be a bit more aggressive with your investments, and you probably aren’t relying on investment income in order to survive.
In this case, your best option is probably to invest cash dividend payments right back into your portfolio. Dividend investing (or dividend reinvestment) allows you to grow your wealth even faster, without requiring as much capital out of your own pocket. Many advisory platforms (especially robo-advisors) allow you to automatically reinvest dividends, too, so this can be an entirely hands-off process depending on your brokerage account.
If you are an older investor, dividend payments can have an impact on your day-to-day cash flow. Rather than investing dividends back into your portfolio, you can utilize any dividends paid as cash in hand. Then, you can spend that money as you would any other taxable dollars.
Depending on the size of your portfolio, the investments you own, and whether you have preferred stock or common stock, these dividend yields could be quite significant. Your dividends might even be enough to passively fund your lifestyle, in fact.
Are dividend payments taxable?
Depending on whether your dividends are classified as ordinary or qualified by the IRS, they will be taxed at different rates.
Regular dividends, also called ordinary dividends, are taxed as ordinary income. This means that you will pay the same tax rate on these earnings as you do the rest of your taxable funds during that same calendar year.
Qualified dividends, on the other hand, are treated a little differently. These dividends are taxed at the capital gains tax rates which — depending where your individual tax bracket falls — could either be 0%, 15%, or even 20%.
Claiming dividend distributions on your taxes
If you get dividends from a company in a given tax year (generally, if they total more than $10), you can expect to receive a form 1099-DIV from the company. (Taxable dividend distributions from life insurance contracts are the exception; in that case, you’ll receive a form 1099-R.) The amount shown on your 1099 will need to be reported as dividend income when you go to file your taxes the following year.
There is one exception to this rule, and that has to do with investment retirement accounts, or IRAs.
In a traditional IRA, your investment savings will continue to grow tax-free until you are ready to begin utilizing the funds. Any dividend payments that are earned in a traditional IRA, as well as any dividend reinvestment growth, all follow the same rules: rather than paying taxes on IRA dividends in the year they are earned/reinvested — as with other dividend payments — you will simply pay taxes on retirement distributions when funds are withdrawn.
With Roth IRAs, contributions are made with after-tax funds. As such, neither the earnings nor future distributions from your Roth IRA are taxable. If your Roth investments receive dividends, these will not be considered taxable income either, as long as you wait to withdraw qualified funds according to IRS regulations.
Final thoughts on dividends
Earning a dividend payment on stocks or mutual funds that you invest in can be a nice financial boost for your pocket and your retirement account. These payouts are essentially free money that you can enjoy — either in the form of cash or additional shares — as your portion of these companies’ profits during a certain period of time.
Dividends are never guaranteed, of course. However, by filling your portfolio with the right type of investments (especially those with a history of dividend paying), you can better your chances of snagging a distribution. Whether you choose to reinvest that or simply spend it, it’s added wealth that you didn’t actually have to work for… and that’s always a good thing.