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What are dividends and how do they work?

Dec. 5, 2023
3 min read

What we'll cover

How dividends are paid to shareholders
Important dividend stock dates to know
How to evaluate when adding to your portfolio

Understanding dividends is an essential part of understanding investing. Whether or not stock prices ebb and flow with market changes, dividends are one way to generate an investment income stream. Let's dive into the ins and outs of dividends.

What are dividends?

Dividends refer to a portion of a company's earnings that are paid to eligible stock owners on a per share basis, typically offered to investors on a regular cadence (for instance, quarterly).

In other words, for every share you own of a dividend stock, you'll receive a dividend payment whenever one is issued. You can generate investment income by investing in individual stocks that pay dividends, as well as dividend-paying funds, like many mutual funds or ETFs . Remember, while dividends can play a role in a diversified, fixed-income portfolio, payments aren't guaranteed for dividend stocks and the amount paid may fluctuate.

How do dividends work?

Let's say you buy 20 shares of a company for a share price of $50 each for a total of $1,000 invested. At the end of the quarter, the company pays $0.50 per share — equaling $10 in dividends.

You can do what you want with your dividend returns, such as reinvest them back into more shares, or you can spend or save the money you receive.

4 important dates for dividends

In the case of dividends, there are four main dates to know: the declaration date, ex-dividend date, the record date and the payment date. Let's go over these in detail.

Declaration date: The date on which the board of directors of a company authorizes, or declares, that dividend payments will go to shareholders.
Ex-dividend date: Determines who is eligible to receive dividends. If you own a stock by the ex-date, you're qualified to receive the payment. But if you buy a dividend stock on or after the ex-date, you aren't eligible for the current dividend payment (as long as you hold onto the stock, you'll be eligible for future payments). And if you own the stock on the ex-date but sell it before the payment date, you'll still receive the dividend.
Record date: Refers to the date when the company compiles its list of shareholders to receive a dividend. Typically, this is one business day following the ex-dividend date.
Payment date: When eligible shareholders will get paid by companies.

How to evaluate dividends

While some think of dividends as a way for retirees to use the market as a source of income, dividend stocks can also be an asset for any investor to consider as part of a diversified portfolio. Here are a few factors to research before investing in dividend stocks:

Dividend history: Begin with how long a company has made dividend payouts and if the amount per share has increased over time — a sign of financial strength — by reviewing the dividend per share (DPS) metric.
Dividend yield: Calculate this by dividing the annual dividend by price. While high dividend yields (4% or above) may sound appealing, it's a good idea to do extra research into stocks with these yields, as they may not be sustainable.
Dividend payout ratio: This number indicates how much of a company's earnings are paid out to shareholders. If a company pays out close to 100% of its profits, its dividend is likely unsustainable and won't be able to withstand a tough financial year. Payout ratios of 80% or lower are typically more sustainable in the long run. You can find payout ratios and dividend yields through Ally Invest.
Dividend tax rate: The qualified tax rate is 0%, 15% or 20%, depending on your taxable income and filing status. (Pay attention to taxes on unearned income, qualified dividends, capital gains and financial ratio of dividend stocks in relation to your goals, risk tolerance and time horizon.)

Tip: Look for the Dividend Aristocrats, which are stocks that have increased dividends for 25 or more consecutive years. This might indicate strong financial standing and that they're more likely to continue paying regular (and rising) dividends — though they're still subject to market risks, just like any investment.

Dividend and conquer

Dividends can be an additional source of investment income. While they're never guaranteed, dividend cash or stock payments can help buoy your portfolio and provide you with more capital to invest or use how you choose.

Before you invest, you should carefully review and consider the investment objectives, risks, charges and expenses of any mutual fund or exchange-traded fund (ETF) you are considering. ETF trading prices may not necessarily reflect the net asset value of the underlying securities. A mutual fund/ETF prospectus contains this and other information and can be obtained by emailing support@invest.ally.com .