Experienced investors know all about dividends but we thought it would be a good idea to explain dividends to newer investors. And perhaps even experienced investors can learn something new here.
A dividend is money that corporations pay our to shareholder. Older, established US companies will pay dividends to shareholders based on what they expect to be able to pay on a regular basis. Dividends are usually paid out quarterly, although there are exceptions and investors should be aware of that. American companies try to maintain the same dividend from quarter to quarter even if earnings fluctuate. Many raise the dividend as they become more profitable. This is not the case for foreign corporations whose dividends can be irregular and based on the profit for the quarter or the year.
Not all corporations pay dividends. Most corporations in their start-up phase use their income to invest in the business for growth. Shareholders in these growing businesses are rewarded by watching their stock price appreciate if the company is successful. But after a while a company will reach a limit on its rate of growth and decide to reward its shareholder with a steady income. There are some issues with dividends however and they have to do with the tax treatment of dividends that differ from the tax treatment of capital gains.
Unlike interest payments to bondholders, corporations cannot deduct dividends as a business expense. For this reason, corporations pay out dividends from after-tax profits. When a stockholder receives a dividend, he also owes taxes in the dividend income. For this reason, dividend income is generally considered to be taxed twice, one at the corporate level and once at the individual level. For example, if a corporation earns $100 it can be taxed up to 39.2%. That leaves $60.80 that can be sent to shareholders as a dividend. If all of it is distributed as dividends, the maximum tax rate on qualified dividends is currently 15%, leaving the shareholder with $51.68. Next year the special 15% rate will be repealed exposing your dividend to a maximum of 43.4%, tax, leaving you with $34.41. Of course these rates apply only to the top tax brackets but they do illustrate how taxes can affect what people have left to spend and why they change their behavior to avoid excessive taxation.
There are a few other things that investors should be aware of when investing in dividend paying stocks and that has to do with dates. A corporation will announce its dividend on one date. It wil also announce what is known as the “ex-dividend date.”
A stock’s ex-dividend date is the first day an owner can sell the stock without losing the rights to its upcoming dividend. Obviously, it’s also the first day a buyer who purchases the stock will not receive that same dividend. A good way to remember how the ex-dividend date works is to think of it as a synonym for “without dividend.”
A third date is the “pay date” which is the date on which the shareholder actually receives the dividend.
Arie J. Korving, a CERTIFIED FINANCIAL PLANNER™ professional, has been delivering customized wealth management solutions to his clients for more than three decades. Prior to co-founding Korving & Company, he was First Vice President with UBS Wealth Management and held management positions with General Electric.