Buying low and selling high isn’t the only way to make money in the stock market. Investing in companies and mutual funds that pay out dividends to shareholders is another popular strategy that can grow a portfolio and generate investment income. Dividends are a way companies and mutual funds transfer profits to shareholders, rewarding them for their investment. Most companies pay dividends as cash, but some distribute dividends in the form of new shares of stock. While cash dividends afford stockholders an immediate payout, stock dividends give shareholders much more flexibility to sell when they want.
A financial advisor can help you invest in assets that generate additional income through dividends
What Is a Cash Dividend?
Like the name implies, a cash dividend is a payment of cash that a company makes to its shareholders. Rather than reinvesting profits into the business, cash dividends allow a company to redistribute a portion of its earnings to investors to reward them for owning shares.
These dividends are typically paid on a per-share basis, meaning a shareholder receives a set amount of money for every share they own. For example, if an investor owns 100 shares of a stock that pays a cash dividend of $0.25 per share, the shareholder would receive an extra $25 from the company.
But since cash dividends transfer capital from a company to shareholders, they reduce the amount of money the company has on hand. If the hypothetical company in the example above had 10 million outstanding shares, its market capitalization would fall by $2.5 million as result of the cash dividends it paid to shareholders. Cash dividends also affect the company’s stock price by approximately the same value of the distribution. If the company in the example above issued a $0.25 dividend for every share owned by investors, its share price would likely fall by the same amount.
Dividend-producing stocks and mutual funds create an extra stream of income within an investment portfolio. However, it’s important to remember that these cash distributions are taxed. How much an investor owes to the IRS on their cash dividends depends on how long they’ve owned the underlying asset. Cash dividends are taxed either at the ordinary income tax rate or a reduced, “qualified” rate of 0%, 15% or 20%. To qualify for a reduced tax rate, the shareholder must own the asset for more than 60 days during the 121-day period that begins 60 days prior to the ex-dividend date.
What Is a Stock Dividend?
A stock dividend is a way for companies to reward investors by granting them more shares of stock. While cash dividends offer an immediate financial incentive for investing in a particular company or mutual fund, stock dividends increase a shareholder’s ownership stake in the company by increasing the number of shares they own.
Like cash dividends, stock dividends tend to affect a company’s stock price. While the overall value of the company remains the same, stock dividends increase the number of shares that exist, resulting in a slightly diluted stock price. For example, if a company with a market capitalization of $1 billion and 10 million outstanding shares issued a 10% stock dividend, it would increase the number of shares that exist by 1 million shares. However, the value of the company would remain the same. That would mean the price of the stock would tick down by roughly 10% because there are 10% more shares in existence.
While cash dividends are more common, a company that is short of cash may use stock dividends as a way to attract additional investment and keep current shareholders happy.
Cash vs. Stock Dividends: What’s Better?
So far, we’ve discussed the principal differences between these two types of dividends, but which one is better? Like so many questions in personal finance, the answer likely varies from investor to investor. If you value the immediate gratification of receiving extra cash, regardless of the tax implications, a cash dividend will likely be preferable. Cash dividends are typically associated with well-established, stable companies instead of growth-oriented businesses still in their infancy.
Stock dividends, on the other hand, can be more valuable if the company still has room to grow. Bonus share of a company’s stock could prove to be far more valuable in the long run than a series of cash payments.
Another key difference between cash and stock dividends is when they are taxed. As mentioned earlier, cash dividends require taxes for the year in which the dividend is received. The size of an investor’s tax bill associated with their cash dividend depends on the amount of time they’ve held the stock or mutual fund that generated the distribution. However, when a shareholder receives a stock dividend, it’s not taxable until the shares are sold. At that point, the net proceeds are considered capital gains and taxed accordingly. This gives the shareholder more flexibility compared to receiving a cash dividend, which can only be cashed out or reinvested, but not deferred.
While some stock dividends may require shareholders to hold their new shares for a set period of time, others come with cash options and can be converted into cash.
From a company’s perspective, stock dividends allow the business to reward its shareholders and incentivize more investment without parting with any of its cash. This can be especially beneficial to companies facing liquidity challenges. However, doing so means existing shareholders will see their shares diluted.
Dividends are the cash or stock distributions that some companies and mutual funds pay to shareholders. While cash dividends result in immediate cash payments to shareholders, stock dividends increase the number of shares that investors in a company or fund own. Cash dividends may be preferred among income investors, but will require taxes to be paid. Meanwhile, stock dividends can be more valuable in the long run, especially if the company that issued them continues to grow. Stock dividends are also not taxable, unless they come with a cash option, making them more tax-efficient than their counterpart.
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Tips for Managing Your Portfolio
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