Running a company is a constant choice between growing the business and taking hard-earned profits. If profits are used to invest in more equipment and other business necessities, they could lead to more profits in the future. Profits paid out to the owners may not add to business growth but they are the ultimate reason for creating and running that business, to return profits to shareholders.
A dividend is those profits paid out to the owners of the business. While small companies may just have one or a few owners, very large companies raise money through selling shares and distributing the ownership over thousands of owners.
The decision to return profits or reinvest in the business isn’t necessarily an either/or decision. Most successful businesses make enough each year to return a little bit of profit as well as invest in future growth. Projects for growth are constantly evaluated for their potential return and how that compares to other ways to use the cash.
For most companies, dividends are paid quarterly according to a fixed amount for every share you own. There are companies that pay dividends twice or once a year, or even monthly but these are the exception rather than the rule.
Most dividend-paying companies pay a fairly constant dividend because they are interested in consistently returning profits to shareholders. For this reason, management often plans several quarters in advance to make sure they will have the money to pay for growth projects and a consistent or rising dividend. When they are sure they will have excess cash, they will raise the dividend. Conversely, the company may cut the dividend amount if management is unsure that the business will have sufficient cash. This is usually considered a bad sign for the company’s profitability and the stock price could decline considerably.
Besides regular cash dividends, a company may find itself with excess cash that it no longer needs. In this case, the Board might approve a ‘special’ or one-time dividend payment. The process of paying out this dividend is the same but it is usually much larger than the regular dividend payments and is extremely rare.
How the process of paying a dividend works
The Board of Directors is a group of people elected to represent you as an owner of the company. When management decides it will have sufficient cash for operations and growth projects, the Board of Directors votes to declare and pay a dividend. The entire process includes four important dates.
The declaration date is the day the dividend is announced by the company to the public. On this date, the company will also announce an ex-dividend date and payment date for the dividend.
The date of record is the date that determines which shareholders will actually receive the dividend.
The ex-dividend date is the first day that the stock trades without the dividend. This means, anyone that did not own the shares prior to this day will not receive the dividend payment. In a confusing twist, the ex-dividend date is usually before the date of record. This is because of the time it takes for share ownership to actually be recorded with the company, usually two business days. For example, if the date of record for a dividend payment in shares of McDonald’s (MCD) is on Friday, the ex-dividend date will likely be on Wednesday of that week. If you sold your shares on Wednesday, you would still receive the dividend payment because your sale would not be recorded with the company until after the date of record when it has determined who gets the payment.
The payment date is the day you will see the dividend appear in your account according to the amount and how many shares you own. For example, if you own 100 shares of the Coca-Cola Company (KO) and the company pays a $0.30 quarterly dividend then you will receive $30 on the payment date.
More Information Here: Ex-Dividend Date Calendar
Qualified versus Non-Qualified Dividends
An important and usually overlooked difference in dividends is that of qualified versus non-qualified dividends. If you have not heard of this distinction, you’re not alone but it could save you a ton of money. Qualified dividends are taxed at the same rate as long-term capital gains, normally one of the lower tax rates you will pay. Non-qualified dividends are added to your regular income and taxed at rates up to almost 40% for those in the top tax bracket.
If you have a $150,000 portfolio, earning 4% in dividends each year and are in the top tax bracket, the difference between qualified and non-qualified dividends could mean an extra $1,500 in taxes and an extra $30,000 over 20 years!
The distinction is largely determined by when and how long you own the shares. The Internal Revenue Service (IRS) states that dividends can be qualified if you own the shares for at least 61 days during the 121-day period around the declaration date of the dividend. For example, if a dividend is declared on March 16th and you purchased the shares on March 5th, you must own them through May 14th for the payment to be determined as qualified. Basically, you need to own the shares for at least four months around the declaration date of the dividend.
The time qualification is the major distinction but companies must also declare dividends as qualified or not and foreign companies must be incorporated in the United States and be domiciled in a country with a tax treaty to be ‘qualified’ dividends. Most companies declare the majority of their dividends as qualified and many foreign dividend payments qualify as well.
This usually isn’t a problem for long-term investors that rarely sell their stocks. You may own the shares for years or decades rather than just a few months. Even when you go to sell shares, the fact that one dividend payment out of many is taxed as unqualified may not make a big difference. Increased taxes only start to bite if you are constantly buying and selling your dividend stocks.
Distributions versus Dividends
Another important distinction in the money you get back from your stocks is that of distributions versus dividends. Many people use the terms interchangeably but there is an important difference.
Dividends are a return of shareholder cash declared by a company. Distributions, most often paid by Real Estate Investment Trusts (REITs) and Limited Partnerships (LPs), are a return of equity in the company. A return of equity (or ownership) is returning part of the company to you the owner.
You pay taxes every year on dividends, whether at the capital gains rate or as income. The amount of distributions you collect are deducted from the original price you paid for the shares. When you sell the shares, you pay taxes on the difference between the sell price and the new, lower price you paid for the shares. Distributions may increase the taxes you own when you sell the shares but may not be due for many years depending on how long you hold the investment. Being able to pay taxes later on money made today is a great advantage of distributions.