What is a Cash Dividend?
A cash dividend is money that a company pays to people who own its stock. The company takes some of the profit it made and gives it to shareholders. This is different from a stock dividend, where the company gives shareholders more stock instead of cash.
Why Do Companies Pay Cash Dividends?
Companies pay cash dividends for a few reasons:
- To reward shareholders for investing in the company
- To attract more people to buy the company’s stock
- The company has extra cash and wants to share it with owners
- Shareholders expect to regularly get some money back
Not all companies pay dividends. Ones that are growing fast usually don’t because they reinvest their profits back into the business. But big, stable companies that make steady profits often do pay regular dividends.
How Cash Dividends Work
Here’s the typical process for how cash dividends work:
- The company’s board of directors meets and votes to pay a dividend. They decide how much cash per share to give out.
- The company announces the upcoming dividend payment publicly. This includes how much per share, the record date, and the payment date.
- The record date is the cutoff. You have to be on the company’s books as a shareholder by this date to get the dividend.
- On the payment date, the company sends out the cash. This is usually done electronically. The money shows up in shareholders’ brokerage accounts.
- The stock price adjusts downward by the dividend amount. This happens so new buyers aren’t getting a freebie.
Dividend Dates to Know
There are 4 important dates to keep in mind with cash dividends:
1. Declaration Date
The declaration date is when a company’s board of directors announces a dividend. They make it official through a statement to the stock exchanges and public. The announcement will give these key details:
- Cash amount per share
- Ex-dividend date
- Record date
- Payment date
2. Ex-Dividend Date
The ex-dividend date is usually 1 business day before the record date. If you buy the stock on or after the ex-dividend date, you won’t get the next dividend payment. The seller gets it instead.
This date is important because the stock price drops by about the same amount as the dividend. Exchanges do this so new buyers after the ex-date aren’t entitled to the money.
3. Record Date
The record date is when a company reviews its books to see who its shareholders are. If you’re a stockholder on the record date, you’ll get the dividend payment. This date is usually 1 business day after the ex-date.
4. Payment Date
The payment date is the day when the company mails out checks or makes electronic payments to give shareholders their dividends. It’s usually a few weeks after the record date.
If you sell your stock between the record date and payment date, you still get the dividend. Your name was on record as a shareholder, even though you got rid of the stock later.
Taxes on Cash Dividends
Most of the time, cash dividends are taxable income. You normally have to pay federal and state taxes on them. There are a couple different tax rates:
- Qualified dividends get special lower rates, usually 0%, 15%, or 20%. It depends on your tax bracket.
- Non-qualified or ordinary dividends are taxed at your regular income tax rate.
For a dividend to be qualified, it must meet certain rules. The company must be a U.S. corporation or foreign company trading on a U.S. stock exchange. You also have to own the shares for more than 60 days.
Consult a tax pro for advice on your specific tax situation with dividends. Taxes can get tricky.
The Downside of Cash Dividends
Getting cash dividends sounds great, but there are some drawbacks to think about:
- The share price drops to adjust for the dividend payment
- You have to pay income taxes on dividends
- A high dividend could mean the company isn’t reinvesting enough in growing
- Dividends are never guaranteed, the company can lower or stop paying them
Some investors prefer companies that don’t pay dividends. They’d rather the company reinvest all its profits to maximize growth. The thinking is you’ll make more as the share price grows over time instead of taking cash out along the way.
Dividend Yield and Payout Ratio
Two key measures to look at with dividends are yield and payout ratio. The dividend yield tells you how much a company pays in dividend each year relative to its stock price. The formula is:
Annual Dividend per Share / Stock Price = Dividend Yield
The payout ratio tells you what percentage of net income a company is paying out in dividends. The formula is:
Annual Dividend per Share / Earnings per Share = Payout Ratio
In general, a high dividend yield may seem attractive. But it could also be a sign that a company is in trouble if the yield is too high. Something to keep an eye on.
The same goes for a high payout ratio. It means the company is paying out most of its income as dividends. This could limit growth and make the dividend hard to sustain if profits dip.
