When it comes to the investment world, there can be a definite learning curve. Even if you don't consider yourself an investor, understanding the basics of how some things can affect your personal finances will allow you to make smarter decisions about your money. In this article, we're answering the question, “what are dividends?” and the role they play in your finances.
What are dividends and how do they work?
According to the financial website, Investopedia.com, the definition of a dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders. Dividends can be issued as cash payments, as shares of stock, or other property.1 Simply put, a dividend is a payment of a company's net profits that's made to its shareholders.
For example, let's say you and your best friend decided to start a small restaurant supply business. To establish ownership, you decide to issue stock - 50 shares to you and 50 to your friend and new business partner - giving you each a 50/50 stock of ownership in the new company. But what happens if a year later you both decide that it's time to grow the business and need the cash to expand?
In this case, you can create new shares of stock and sell them to individuals who are interested in investing in your business (known as stockholders). When your business earns a profit, you can either reinvest those dollars back into your business, or issue dividend payments to your stockholders, who are also considered owners along with you and your friend. Owning stocks that pay dividends means that your stockholders are relying on your company to be successful and keep paying dividends. Payment distributions for dividends can be structured as a one-time special dividend or as an ongoing cash flow to all stockholders.
From an investment and savings standpoint, stocks that pay dividends can be a good way to create a stream of taxable income. But like many investments, nothing is guaranteed. At any time, companies have the option of cutting their dividends or even eliminating them. For example, a company could experience financial difficulties, forcing them to reduce or suspend issuing dividends for a specific period of time. The choice is up to them.
How do dividends impact my personal finances?
If you have some type of retirement savings account, you're probably receiving dividends. How? Because many retirement accounts include mutual funds that contain a mix of different stocks that pay dividends. When a mutual fund collects the dividends, they share the profit with you, the account holder who holds shares in the fund. For this reason, it's important to regularly review your retirement accounts to discuss the performance of your mutual funds with a qualified financial planner or other retirement professional.
Note: The information in this article is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation.