What's a dividend and how does it work?

Bonds aren’t the only way investors can get a recurring income stream. Dividends—regular payouts from investing in a company’s equity—can be used to pay bills and supplement Social Security in retirement. We explore how dividends work, see how they compare with bonds, and review the different ways to purchase a dividend income investment.

What's a dividend and how does it work?

You may have been paid a dividend and didn’t even know it. If you own shares of a mutual fund, chances are you received a dividend distribution within the last year. That’s because 80% of the companies in the S&P 500 Index paid dividends in 2017, which comes out to an average of $12.79 per share. In fact, $420 billion was paid out to investors in that year alone, according to S&P Dow Jones Indices.

Before investing in a dividend-paying stock, it’s important to understand how dividends work, because there’s rarely reward without some risk.

Why companies pay dividends—and how

A profitable company can handle its earnings in different ways: It can retain earnings to help grow the company, pay off corporate debt, buy back some publicly traded shares, or pay dividends to reward shareholders. The latter two options are the most visible to investors, because share buybacks and the dividend issuance of high-profile companies can make news headlines.

Companies that pay dividends tend to issue them on a regular basis, usually quarterly. The shareholder can receive the dividend in cash or participate in an automatic reinvestment plan, where the payout is used to buy more shares. If the dividend stock is held in a mutual fund, the dividend is called a distribution, and it’s paid out annually.

Some companies have been paying dividends for many years. Dividend Aristocrats are companies that have increased dividends for at least 25 years, and the S&P 500 Index has created an index to track their performance. Dividend Kings—a smaller list of companies—have raised dividends for 50 consecutive years.

Just because a company has been paying a dividend for a long time doesn’t mean it will continue to do so. Because dividends are paid out of earnings, payouts may increase, decrease, or be stopped altogether if earnings fall. This is one of the risks of counting on dividends for a steady income: There’s a chance a company may change its dividend policy unexpectedly.

What's dividend yield and how is it calculated?

  • Dividend yield is a financial ratio that shows how much a company pays out in annual dividends relative to its share price
  • The formula for dividend yield: Annual dividends per share / Price per share

Dividend-paying stocks aren’t the same as bonds

Dividend stocks and bonds may appear similar, since they both provide a regular income. But they’re actually different in some important ways—including how stable the income is, how each investment responds to the economy, and through their tax treatment. 

Five differences between dividend-paying stocks and bonds

  Dividend-paying stocks Bonds
Stability of income Dividends are an optional payout to stockholders based on earnings; they may fluctuate or cease to be paid Bonds pay a required interest payment to bondholders based on issuance. Payments remain stable
Yield Determined by how much a company pays out in dividends relative to share price Calculated as coupon payment divided by market value of the bond
Capital appreciation Capital appreciation is possible, meaning your investment could be worth more by the time you sell it Although bond prices can fluctuate, principal is repaid when a bond matures (barring a default)
Economic sensitivity Because dividends are paid out of a company’s profits, they can be correlated to the strength of the economy Bond income can come from a variety of sources, including company profits, mortgage payments, and taxes, depending on the issuer and type of bond. Each will have different degrees of economic sensitivity
Tax treatment Currently taxed lower than ordinary income. Distributions are tax deferred if held in a retirement account Taxed as ordinary income

Are dividends right for you?

If you’ve decided dividends might be a suitable addition to your portfolio—or you want to increase the amount of dividends you’ve already been receiving—there are a number of ways you can invest. To target your investment to a specific company, you can buy a dividend-paying stock on its own. You can also consider a diversified strategy, such as buying a dividend income mutual fund, closed-end fund, or exchange-traded fund (ETF). A pooled investment such as a fund will offer access to a range of stocks, so you may be less likely to lose income if one company lowers or stops paying a dividend. Your financial professional can provide guidance around matching a dividend income investment with your lifestyle and retirement planning goals.