What Are Dividends?

"Money for Nothing" is not only the title of a song by the band Dire Straits from the 1980s, but it is also the feeling many investors get when they receive a dividend. All you 🦂have to do is buy shares in💧 the right company, and you'll receive some of its earnings.

Dividends are one way companies "澳洲幸运5开奖号码历史查询:share the wealth" generated from running the business. They are usually a cash payment, often drawn from earnings, 澳洲幸运5开奖号码历史查询:paid to the investors of a company—the shareholders.

These are paid on an annual, or more commonly, a quarterly basis. The companies that pay them are usually more stable and established, not "fast growers." Those still in the rapid growth phase of their 澳洲幸运5开奖号码历史查询:life cycles tend to retain all the earnings and re💮invest them into thꦅeir businesses.

Understanding Dividends: Price Implications

When a dividend is paid, several things can happen. The first of these are changes to the price of the security and various items tied to it. On the 澳洲幸运5开奖号码历史查询:ex-dividend date, the stock price is 澳洲幸运5开奖号码历史查询:adjuste🐽d downward by the amount of the dividend by the exchange on which the stock trades.

For most dividends, this is usually not observed amid the up-and-down movements of a normal day's trading. It becomes easily apparent, however, on the ex-dividend dates for larger dividends, such as the $3 payment made by Microsoft in the fall of 2004, which caused shares to fall from $29.97 to $27.34.

The reason for the adjustment is that the amount paid out in dividends no longer belongs to the company, and this is reflected by a 澳洲幸运5开奖号码历史查询:reducti♔𝔉on in the company's market cap. Instead, it belongs to the individual shareholders. For those purchasing shares after the 澳洲幸运5开奖号码历史查询:ex-dividend date, they no longer have a claim to the dividend, so the exchange 澳洲幸运5开奖号码历史查询:adjusts the price downward to reflect this fact.

Historical prices stored on some public websites also adjust the past prices of the stock downward by the dividend amount. Another price that is usually adjusted downward is the 澳洲幸运5开奖号码历史查询:purchase price for 澳洲幸运5开奖号码历史查询:limit orders.

Because the downward adjustment of the stock price might trigger the limit order, the exchange also adjusts outstanding limit orders. The investor can prevent this if their broker permits a 澳洲幸运5开奖号码历史查询:do not reduce (DNR) limit order. Note, however, that not all exchanges make this adjustment. The U.S. exchanges do, but the 澳洲幸运5开奖号码历史查询:Toronto Stock Exchange, for example, does not.

On the other hand, 澳洲幸运5开奖号码历史查询:stock options prices are usually not adjusted for o💙rdinary cash dividends unless the dividend amount is 10% or mဣore of the underlying value of the stock.

Implications for Companies

Dividend payments, whether cash or stock, reduce 澳洲幸运5开奖号码历史查询:retained earnings by the total amount of the dividend. In the case of a 澳洲幸运5开奖号码历史查询:cash dividend, the money is transferred to a liability account called dividends payable. This liability is removed when the company makes the payment on the dividend 澳洲幸运5开奖号码历史查询:payment date, usually 🎀a few weeks after the ex-dividend date.

For instance, if the 🧔dividend was $0.025 per share, and 100 million shares are ﷽outstanding, retained earnings will be reduced by $2.5 million, and that money eventually makes its way to the shareholders.

In the case of a 澳洲幸运5开奖号码历史查询:stock dividend, however, the amount removed from retained earnings is added to the equity account, 澳洲幸运5开奖号码历史查询:common stock at 澳洲幸运5开奖号码历史查询:par value, and brand new shares are issued to the shareholders. The value of each share's par va🌠lue does not🔯 change.

For instance, for a 10% stock dividend where the par value is 25 cents per share, and 100 million shares are outstanding, retained earnings are reduced by $2.5 million, common stock at par value is increased by that amount and the total numbꦯer of shares outstanding is increased to 110 million. 

This is different from a 澳洲幸运5开奖号码历史查询:stock split, although it🎶 looks the same from a shareholder's point of view. In a stock split, all the old shares are called in, new shares are issued, and the par value is reduced by the inverse of the ratio of the split.

For instance, if instead of a 10% stock dividend, the above company declares an 11-to-10 stock split, the 100 million shares are called in, and 110 million new shares are issued, each with a par value of $0.227. This leaves the common stock at par value account's total 澳洲幸运5开奖号码历史查询:unchanged. The retained earnings account is not reduced either.🍃

Implications for Investors

Cash dividends, the most common sort, are taxed at either the normal tax rate or at a reduced rate of 20%, 15%, or 0% for U.S. investors. This only applies to dividends paid outside of a 澳洲幸运5开奖号码历史查询:tax-advantaged account such as an IRA.

The dividing line between the normal tax rate and the reduced or "qualified" rate is how long the 澳洲幸运5开奖号码历史查询:underlying security has been owned. According to the IRS, to qualify for the reduced rate, an investor has to have owned the stock for 60 consecutive days within the 121-day window centered on the ex-dividend date. Note, however, that the purchase date does not count toward the 60-day total. Cash dividends do not reduce the basis of the stock. 

Corporations can be investors, too. When corporations invest in other dividend-paying companies, they may exclude a portion of t🔜he dividend𓃲 income they receive. This deduction avoids the double taxation🐷 of income.

Capital Gains

Sometimes, especially in the case of a 澳洲幸运5开奖号码历史查询:special, large dividend, part of the dividend is declared by the company to be a 澳洲幸运5开奖号码历史查询:return of capital. In this case, instead of being taxed at the time of distribution, the return of capital is used to reduce the basis of the stock, making for a larger 澳洲幸运5开奖号码历史查询:capital gain down the road, assuming the selling price is higher than the basis.

For instance, if you buy shares with a basis of $10 each and you get a $1 special dividend, 55 cents of which is return of capital, the taxable dividend is 45 cents, the new basis is $9.45 and you will pay 澳洲幸运5开奖号码历史查询:capital gains tax on that 55 cents when you ꦡsell your shares sometime in the future. 🔯

There is a situation, though, where return of capital is taxed right away. This happens if the return of capital would reduce the basis below $0. For instance, if the basis is $2.50 and you receive $4 as a return of capꩵital, your new basis would be $0, and you would owe capital gain tax on $1.50.

The basis is also adjusted in the case of stock splits and stock dividends. For the investor, these are treated the same way. Taking our 10% stock dividend example, assume you hold 100 shares of the company with a basis of $11. After the payment of 💞the div𓂃idend, you would own 110 shares with a basis of $10. The same would hold true if the company had an 11-to-10 split instead of that stock dividend.

The Bottom Line

Finally, as with everything else regarding investment record keeping, it is up to individual investors to track and report tಌhings correctly. If you have purchases at different times with different basis amounts, return of capital, stock dividend, and stock split basis adjustments must be calculated for each.

Qualified holding times must also be accurately tracked and reported by the investor, even if the 澳洲幸运5开奖号码历史查询:1099-DIV form received during 澳洲幸运5开奖号码历史查询:tax season states that all paid dividends qualify for the lower tax rate. 🎐The IRS allows the company to report dividends as qualified, even if they are not, if the determination of those that are qualified and those that are not is impractical for the reporting company.

Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal. Investors should consider engaging a qualified financial and/or tax professional to determine a suitable investment strategy.