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In a nutshell
Dividend stocks are stocks that pay dividends. Dividends are payouts that companies make to shareholders, and they’re typically paid quarterly. They can be a good source of passive income.
- You can invest in dividend stocks by buying individual stocks or via funds that include stocks with historically strong dividends.
- The amount of tax you owe on a dividend will depend on the amount of time you held the stock.
How dividend stocks work
Dividends are payments companies make to shareholders as a reward for owning a stock. They can be an incentive for shareholders to continue holding the stock and evidence of a company’s strong financial performance.
A company’s board of directors will decide on the amount and frequency of dividends. They are typically paid out quarterly — but can also be paid monthly, annually or just one time. A one time dividend is known as an extra (or special) dividend.
Companies will usually pay out these dividends as cash, but a company can also designate additional stocks for its payouts called stock dividends. Shareholders usually get dividends based on how many shares they have. For example, an investor holding 50 shares of a company that pays 20 cents per share would get $10. An investor can either keep the cash or reinvest their dividends.
There are several key dates dividend investors should know:
- The declaration date: This is the date when the board of directors announces a dividend.
- Record date: The record date determines an investor’s eligibility to get a dividend. A shareholder must be on the company’s books by the record date in order to receive the dividend.
- Ex-dividend date: The stock exchange that a stock trades on sets the ex-dividend date, and it’s usually a day after the record date. If an investor buys the stock on the ex-dividend date (or after), the seller receives the dividend instead.
- Payment date: As the name implies, this is the date shareholders are paid their dividends.
How to invest in dividend stocks
You can invest in dividend stocks by buying individual stocks or dividend funds:
- Dividend funds are baskets of securities, including stocks that have historically offered impressive dividends. Investing in funds allows you to spread your money out across various securities, and this diversification reduces your risk (versus choosing a few stocks and hoping they are profitable).
- You can buy both individual stocks and dividend funds via brokerage platforms, such as Charles Schwab, Fidelity Investments and Robinhood.
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Disclosure
When choosing dividend stocks, one measure is particularly useful: the dividend yield. This figure shows how much a company is paying in dividends relative to the price of its stock, and investors tend to use it to see how much return they’re getting on their investment.
While a higher dividend yield is typically better, this isn't always the case. Make sure to find out why a particular dividend yield is high. If the yield jumps because the stock price is plummeting, the stock may not be a good investment. For context, the S&P 500’s dividend yield is around 1.3%, as of May 2024.
Another figure to look at is the payout ratio, or how much of a company’s total earnings are going to dividends. A high payout ratio may sound like a good deal for investors, but it can also signal that a company is struggling but doesn’t want to lose investor support by cutting dividends. The figure can give you insight into whether a company will be able to continue paying dividends at the same rate.
Instead of getting caught up in what a company is paying shareholders at the moment, take the time to assess its history. Does the company regularly increase dividends? How often? Some of the most well known dividend stocks, like Johnson & Johnson, have steadily increased their payouts over time.
If you opt for a dividend fund instead of an individual stock, you also need to look at factors like how the fund manager chooses dividend stocks to include (if the fund is actively managed) and the fees associated with investing in the fund.
The risks associated with dividend stocks
Dividends can be a great way to earn income, but like all investments they come with risks.
While the dividend yield is a good way to measure how much return an investor is getting on an investment, it can also be a sign of a risky investment if it’s too high. Investors may see a high dividend yield and buy a stock that’s not actually a good investment for them.
Dividends are also not guaranteed. While some companies are known for their history of providing steady dividends, they can cut these dividends at any time. Dividends are at risk of being cut amid challenging economic environments or when a company is performing poorly. Many companies, including Disney and Delta, paused their dividends during the pandemic, for example.
Typically, dividend paying companies are more mature in their lifecycle. Usually, they’re not spending as much on research and trying to quickly build up their company. This means they may not be as high growth as other stocks — although there are exceptions.
Dividend stocks also come with all the risks of investing in stocks, including market volatility. Financial advisers tend to recommend abstaining from investing money that you could need within the next three to five years.
How are dividends taxed?
When you receive dividends, you’ll likely need to pay tax on them. The amount of tax you owe on dividends depends on whether the dividend is considered “qualified.”
To be qualified, dividends must be paid by a U.S. corporation (or a qualified foreign one) and held for 60 days during the 121-day period that starts 60 days before the ex-dividend date. (There are exceptions outlined in IRS publication 550.) Depending on your taxable income and filing status, qualified dividends are taxed at 0%, 15% or 20%.
Nonqualified dividends, also known as ordinary dividends, are taxed as ordinary income, which means the maximum tax you’ll pay on them in 2024 is 37%.
Tips on how to monitor and manage your dividend portfolio
Dividends provide a way to generate steady income in your stock portfolio, but you don’t want to get too caught up in chasing high yields. While every investor’s approach should be tailored to their risk tolerance and goals, these tips can help you maintain a sustainable dividend portfolio:
- Invest for the long term: As with all investing, the key to building wealth through dividend investing is choosing assets that will generate returns over the long term. That could mean foregoing a risky stock with a higher dividend yield for one with a lower yield but a strong history of dividend growth. It also means not reacting to market moves, like selling when a stock plummets. Weathering volatility is a huge part of investing.
- Diversify: Investing in dividend stocks of various sizes and sectors will help diversify your portfolio and lower your overall risk. When one area of the stock market plummets, another may hold steady or even soar, so you don’t want to have all your eggs in one basket — even one that pays high dividends.
- Reinvest your dividends: Let your dividends take advantage of compound interest. While your investing strategy will ebb and flow — and you may eventually use income from dividends to cover expenses — reinvesting them will likely allow your portfolio to generate higher returns over the long term.
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Dividends are a great way to generate passive income in your portfolio, whether you’re a young investor, a retiree or someone in between. But it’s important to understand the risks of investing in these stocks, how they’re taxed and whether they align with your overall investing strategy. Measures like the dividend yield and payout ratio can help you assess the level of return you’re getting on your investment.
Frequently asked questions (FAQs)
What should I do if a stock I own stops paying dividends?
Whether or not you should shift your portfolio by selling a stock after it stops paying dividends depends on several factors. If the main reason you bought the stock is for its dividend payments — if you’re a retiree looking for income, for example — you may want to consider shifting your portfolio to other income generating investments, like bonds. But you also need to consider the tax burden of selling the stock, whether you’re selling at a loss and whether the stock still aligns with your long term financial goals.
What is the difference between dividend stocks and dividend funds?
Dividend stocks are individual stocks, such as Pepsi or Verizon, that pay dividends. Dividend funds are baskets of stocks, with an emphasis on stocks with strong dividends. Investing in funds instead of individual stocks is a way to get exposure to a mix of investments in your portfolio.
Can I invest in dividend stocks through mutual funds or ETFs?
Yes, dividend funds can be mutual funds or exchange traded funds (ETFs).
Is it better to invest in high-yield or low-yield dividend stocks?
The higher a dividend yield is, the more income you’re getting for your investment in a stock. But a high dividend isn’t always a good thing because it can mean that a stock’s share price has dropped — or that a stock has a high dividend yield that it can’t maintain.
How can I tell if a dividend is sustainable?
You can assess if a dividend is sustainable by looking at the payout ratio. While there is no ideal payout ratio (since companies have varying goals and financials), you can look at how much a payout ratio has changed over time. A 100% payout ratio means that a company is paying all its earnings in the form of dividends, and a payout ratio of more than 100% means a company is paying more in dividends than it earns.
AP Buyline’s content is created independently of The Associated Press newsroom. Our evaluations and opinions are not influenced by our advertising relationships, but we might earn commissions from our partners’ links in this content. Learn more about our policies and terms here.