10 Most Important Dividend Definitions You Need to Know
By: Ned Piplovic,
Amid a range of seasoned investors to complete novices, every investor seeking to venture into dividend-paying equities should be familiar with some elementary concepts, basic terminology and few important dividend definitions.
The list below contains the 10 most important dividend definitions to know to start investing in dividend-paying securities. These basic dividend terms will help investors who seek to produce a steady flow of income through their respective portfolios..
#1 Most Important Dividend Definitions You Need to Know
Dividends are distributions of a company’s earnings to its shareholders. Some types of securities, such S-Corporations, partnerships, limited liability corporations, trusts and estates, use the term distributions instead of dividends. While there are differences between the payouts from the different types of securities, the basic idea is identical. A corporation, a mutual fund, an exchange-traded fund (ETF), an LLC or any other security distributes a portion of its assets to the individuals or legal entities that hold shares or units of that security.
#2 Most Important Dividend Definitions You Need to Know
The dividend yield represents the ratio of the total annual dividends per share and the current share price. Evaluating the dividend payouts as a portion of the equity’s share price easily allows investors to compare the level of dividend income distributed in relation to the funds invested. A high dividend payout does not necessarily indicate a good investment if the equity’s share price is too high. For instance, a $2.00 annual dividend payout from an equity with a $50 share price has a dividend yield of 4% and is a better investment option than a security with a $4.00 annual dividend payout that yields only 2.5% because its share price is $160. This is just an example to illustrate the dividend yield. Investors should not make their investment decision solely based on the equity’s dividend yield. Indeed, investors must evaluate many considerations to determine the best securities for their investment portfolio.
#3 Most Important Dividend Definitions You Need to Know
Dividend Payout Ratio
The dividend payout ratio indicates the share of earnings that a company distributes to its shareholders as dividends. While some securities – such as C-corporations or limited liability companies (LLCs) – can choose to distribute any portion of their earnings as dividends, other securities – such as real estate investment trusts (REITs) or mutual funds – have to follow specific requirements to enjoy certain privileges. For instance, a REIT “must distribute at least 90 percent of its taxable income to shareholders annually in the form of dividends” to enjoy favorable tax terms and lower tax rates.
#4 Most Important Dividend Definitions You Need to Know
The ex-dividend date is the date on which the company’s stock, or any other security, begins trading “ex-dividend,” or when a new investor will need to wait until the next period to receive a payout. On the ex-dividend date, the amount of the upcoming dividend payout is deducted from the share price. This date is one of four key dividend dates. The Declaration Date, the Record Date and the Pay Date are the other three. However, while these three dates are merely administrative, the ex-dividend date determines which investors receive the upcoming dividend distributions paid on the next pay date. To receive the next dividend distribution, an investor must own the shares on the day prior to the ex-dividend date. For any transaction that occurs on the ex-dividend date, the seller of the security will be deemed as the shareholder of record and will receive the dividend distribution. The buyer of the security will not be eligible to receive dividend distributions until the following period.
#5 Most Important Dividend Definitions You Need to Know
Cash dividends are the most common type of dividend distributions, where the shareholders receive their dividend distributions in the form of cash equivalents. Most commonly, the company will mail out dividend checks on the dividend pay date or initiate an electronic funds transfer to a designated brokerage or investment account. The ease of handling, convenient distribution and ease of accounting for tax purposes make cash dividends the preferred type of dividend distribution by most companies.
#6 Most Important Dividend Definitions You Need to Know
Stock dividends are dividend distributions by which investors receive additional shares of the company’s stock in value equivalent to the declared cash distribution. The main advantage of stock dividends for the company distributing the dividends is that the company does not have to have cash on hand to distribute this type of dividend. The main advantage for the investor is that the Internal Revenue Service (IRS) treats stock dividends as stock splits. Therefore, the stock dividend distributions will carry no tax liability in the year in which they are handed out. The investors incur tax liability only upon the sale of the shares. Even then, the gains are subject to lower, capital gains tax rates, which apply only to a certain types of cash dividends.
#7 Most Important Dividend Definitions You Need to Know
Qualified dividends are a type of dividend distributions that qualifies for taxation under the capital gains tax rates schedule, as opposed to Ordinary Dividends, which are taxed at regular, higher income rates. To attain the qualified status, dividends must be distributed by a U.S. corporation and meet additional requirements set out in the IRS Publication 550. Under the detailed rules of this publications, some foreign companies that meet specific criteria can obtain the “qualified” status for their dividend distributions.
#8 Most Important Dividend Definitions You Need to Know
As their name implies, ordinary dividends are regular dividend distributions that securities distribute to investors – generally as cash payouts – and are subject to taxation as ordinary income. Unless specifically identified as qualified dividends, it is safe to assume that the payouts are ordinary dividends. The sure identifier is that the taxable income amount for all ordinary dividends appears in box 1a on the IRS Form 1099-DIV. Some dividend distributions – such as dividend distributions from tax-exempt companies, master limited partnerships (MLPs), real estate investment trusts (REITs), special dividends, etc. – are always classified as ordinary dividends. Additionally, any interest distributions from money market accounts or dividend distributions associated with hedging are always ordinary dividends.
#9 Most Important Dividend Definitions You Need to Know
Special dividends – or one-time dividends – are dividend distributions that companies pay out occasionally to distribute earnings to shareholders because of a sudden cash influx due to the sale of a portion of the business, a lawsuit award, investment liquidation, etc. Special dividends are distributed in addition and unrelated to the company’s regular dividend distributions.
#10 Most Important Dividend Definitions You Need to Know
Dividend Reinvestment Plan – DRIP
Dividend Reinvestment Plans are plans designed to roll over investor’s cash dividends into share purchases automatically. The main advantage of DRIPs is that most plans do not charge any fees and commissions which can greatly increase the total return on investment over extended periods.
Armed with these most important dividend definitions, any investor can begin to discover the benefits of investing in dividend-paying equities. The use of dividend investments can supplement asset appreciation with a steady flow of payouts to boost total returns.
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Ned Piplovic is the assistant editor of website content at Eagle Financial Publications. He graduated from Columbia University with a Bachelor’s degree in Economics and Philosophy. Prior to joining Eagle, Ned spent 15 years in corporate operations and financial management. Ned writes for www.DividendInvestor.com and www.StockInvestor.com.