How Do Dividends Work?

A dividend is a payment made by a corporation to its stockholders as cash or stocks. As a shareholder, you can think of a dividend as your share of the company’s profits. Stock prices for financially secure companies typically don’t move much, and dividends are offered to entice, reward and retain investors.

Well-established companies often raise dividends over time. A company that has earned a reputation for delivering reliable dividends generally works hard not to disappoint investors. Such firms likely are financially healthy, generating more consistent cash flow and lower risk than corporations that don’t pay dividends.

Investing in dividend stocks allows younger people to generate wealth over the long haul and older adults to build a steady income during retirement. Your first step would be to research the kinds of companies that pay dividends and are considered reliable in their payments.

With dividend investing, the more often you receive and reinvest your dividends, the higher your eventual rate of return. A dividend reinvestment plan or DRIP allows investors to automatically reinvest cash dividends by purchasing additional shares or fractional shares on the dividend payment date. Instead of receiving your quarterly dividend check, you put the money directly toward the purchase of additional shares.

Many DRIPs let you buy additional shares commission free and even at a discount relative to the current share price. DRIPs are operated by the company itself. Certain DRIPs extend the offer to shareholders to buy additional shares in cash, directly from the company, at a discount of between 1% and 10%. With the discount and commission-free structure, the cost basis of shares can be significantly lower than it would be if the shares were bought outside the DRIP, another perk of dividend reinvestment plans.

From the company’s standpoint, selling DRIP shares means that the proceeds can be reinvested into the firm and allow it to raise new equity capital over time while reducing cash outflows from the dividend payments.

From your point of view, DRIPs offer a convenient way to reinvest. However, you must pay taxes on the cash dividends reinvested in the company even though you don’t receive any cash.

You may dream of reading by a pool and living off the passive income from dividend checks. Most dividends are paid quarterly, although some companies pay annually. Most companies pay in cash or stock, but there are even property dividends, which are paid in goods. Property dividends can take the form of railroad cars, cocoa beans, pencils, gold, silver, salad dressing or any item with tangible value and are recorded at market value on the declaration date.

People who invest in dividend stocks see them as an investment strategy that can provide investors with a secure stream of lifetime cash flow without selling shares of stock or touching their principal.

Standard and Poor’s keeps track of a list of S&P 500 companies that have grown their dividend every year for at least 25 consecutive years; it’s known as the S&P Dividend Aristocrats Index. These companies include household names like 3M, AT&T, Chevron, Coca-Cola and Walmart.

When you retire, you can stop reinvesting and simply take the dividends as income. The income is generated by your investments. But research needs to be done on the tax consequences of any dividend strategy. As with any investment plan, you have to consider your particular situation and comfort with various levels of risk. Consult with a qualified professional before entering into any investment program.

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