You’ve probably heard or read about dividends and dividend income, and you’re probably wondering what it is and how can it help you to reach your financial goals.
Well, don’t worry, in this article, we’ll explain a few things on how dividends work and how they are taxed.
1. What is Dividend Income?
Every company or organization makes profits and those profits can be reinvested into the business by paying rent, buying inventory, etc. Some of those must be given to shareholders as they have to be paid for providing capital to the business or company.
These profits are paid out in dividends. So what are dividends?
A dividend is profits paid out to shareholders of a company. So these accumulated earnings are owed to the shareholders and paid out as such.
2. How Are Dividends Processed?
All shareholders will receive equal dividend payments. This is separated by class. These classes can be normal, special, or foreign.
So different classes have different amounts they get awarded and everyone in that class should be rewarded equally.
But of course, if one investor has let’s say 1200 shares and another one has 760, then even though the share price paid to both would be the same, the investor with more shares will get more dividend income in total.
The distribution of these dividends is approved by the Board of Directors and once declared, they will be distributed on a certain date.
This date is called the payable date.
3. How Businesses Manage Dividend Income
Every year, dividends are paid out to shareholders and this amount is determined through the dividend yield which is divided by the share price against each share.
They can pay out the yield or they can buy back stock to decrease the outstanding share count.
Not all companies will pay out dividends though, some growing companies might decide to keep the profits, a process that’s called retained earnings. This will help them to reinvest the money and focusing on growing the company even higher.
This will in turn transform into capital gains for the shareholders.
4. There are Many Types of Dividends
Even though the cash dividend is the most popular, there are other types of dividends out there. These include share repurchase, property dividend, scrip dividend, liquidating dividend.
Stock dividend is when the company doesn’t have enough funds to pay out cash dividends to their shareholders so instead they issue company stocks to give to the investors to keep them satisfied until the company starts making a profit.
A share repurchase is when the company wants to regain their shares from the open market so they essentially buy back some of the shares that they have initially issued. It is an alternative to returning capital to shareholders and is used to boost a company’s earnings per share.
It is a clever method to increase the corporation’s standing before quarterly reports and gives the potential for increased profits in the future.
Property dividends are when the business will give out some of their assets instead of cash to their investors. The asset can be anything, from land, inventory, equipment, etc.
When a company is low on funds and doesn’t have enough to issue dividends, they could offer scrip dividends. A scrip dividend is basically a note that is issued by the company to their shareholders promising to pay them when they have enough funds to pay out dividends.
A liquidating dividend is when a business issues cash or another type of dividend to its shareholders before closing down the company.
5. How is Dividends Income Taxed?
All dividend income is taxed, pretty much any dividend that brings you $10 or more (per taxable year) will have to be reported.
Dividend income can be taxed in two ways:
You either have qualified dividends and then get the chance to lower your tax rate (even up to 0%), or you have non-qualified ordinary dividends that you will have to pay the normal tax rate as your other sources of income.
To get qualified dividends with the hopes of lowering your capital gains tax, you will have to meet certain requirements such as: holding the company shares for a minimum period of time (60 days) and getting your dividends paid by either a U.S company or a foreign corporation that’s qualified.
Reference source: IRS
6. Capital Gains vs. Dividend Income
While capital gains and dividend income are two ways that shareholders could make money by investing in a company, they are not the same thing and are taxed differently.
Dividend Income vs Interest Income
If shareholders receive dividends or interest payments from a company, they will become tax liable. Because they are not the same kind of payment, they are not treated the same when it comes to paying taxes.
It doesn’t cost a company anything to distribute dividends to their investors. But when the company makes interest payments for paying their debt for example, then this becomes an expense and can have a reduced taxable income.
In the eyes of the IRS, there is no difference between interest income and nonqualified dividends, so they are both taxed at the same normal rate.
Dividend Income vs Capital Gains
When investors put money into a company, the initial sum that they have invested is called capital. If the company grows in value, so does the capital of the shareholders, and this is called capital gains.
Investors will only have capital gains if their initial investment is sold at a profit. The tax rate on capital gains depends on how long the investor kept stock in the company before deciding to sell.
A short example of how capital gains work: If you buy 100 shares of a company’s stock at $1 per share, that means your initial capital is $100 (100 x $1 = $100).
Let’s say that company stock grows and reaches for example $2 per share, then your investment value is now $200 (100 x $2 = $200).
So if you decide to sell your shares, you will end up with $200, and the capital gains are the difference between your initial capital investment and the ending total capital: $200 (value of shares now) minus the $100 (your initial investment), means that your capital gains are $100.
7. Finding The Right Company To Invest In
Dividends income is an amazing passive way to make money. Even if the profits are not that high, you could still use some of that money to pay for bills, buy groceries or go out to some fancy dinners every now and again.
The more shares you buy the more chances you have to get a higher dividend income.
Of course, deciding on which company to invest your money into is not that simple, because losses do happen all the time.
It all depends on your risk factor and how much money you’re willing to invest or to lose, and how fast you want to make a profit.
You might see people rushing and buying stocks for the newest and hottest shiny company that’s viral now and gone in a few weeks or months, and then end up with a total loss.
While this tactic can bring you some profits, it’s not always recommended especially for beginner investors.
Beginner investors should start out by focusing more on established companies that have been around for a while now and that have a more stable stock, (these usually come with a higher purchase price though).
Dividend Income: Final Words
Probably the most important takeaway would be to make sure your dividends are qualified for tax relief. You don’t want to have ordinary dividends, not if you want to make a lot of profit in the long run. So keep hold to those shares a while longer to qualify for better tax rates.
You should also keep track of your stocks and the companies that you have invested in at least a few times a week if possible, if not daily. There are tons of apps that you can use that make this process much easier these days.
Be sure to read and get as much knowledge on the investment market, especially the companies that you decide to buy shares of.
Investment is a risky game and the more knowledgeable the more chances you have to make a profit instead of losing your money. Always try to determine whether the risks are worth it for your current financial situation or portfolio.
As an investor, your only “job” is to research and study the markets for potential investments every chance you get, in order to diversify your portfolio even more, and have more sources of income.