If you own stock, you may see dividends showing up in your brokerage account. They may show up in different forms—as small amounts of cash, or as fractional shares. What they are, in their simplest form, is a direct return on your investment.
What is a stock dividend?
Stock dividends are payouts, or rewards, paid by companies to their shareholders as a share of the company’s profits. While they’re typically distributed as cash, they are sometimes rewarded in the form of additional, or fractional shares.
For example: if you had 100 shares of Microsoft stock, and received a dividend of 0.05 shares for each share you own, then you would receive five additional shares.
The downsides of dividends
When a company issues a dividend in the form of additional shares, it needs to ensure it’s not diluting the value of existing shares. A company can erode the value of its existing shares when it creates more shares, which can reduce a shareholder’s stake, rather than increasing it.
In effect, dividends can act as a stock split. A company splits its stock when it wants to increase the total number of its outstanding shares on the market. Splitting stock simultaneously creates more shares while retaining the value of your holdings.
What can you do with dividends?
Investors can either reinvest their dividends to increase their holding in a company or cash them out.
While reinvesting your dividends may offer more long-term growth opportunities, cashing them out means putting money directly into your hands. Cash dividend payments tend to be affected more by inflation, whereas stock values can often increase at rates above inflation over time—though that’s not necessarily guaranteed.
Combining reinvestment options
Investors can also sell any new shares received from a dividend payout, and buy other stocks or funds with the proceeds. This can help diversify your portfolio.
You’ll want to keep in mind, however, that investing in other company’s stock will require some research, to ensure your new investment matches your financial goals.
Should you reinvest dividends?
There are investment tools designed to help you reinvest your dividends if you wish to do so. The dividend reinvestment plan is specifically designed to invest in stock shares of another publicly traded company.
But should you reinvest your dividends? If the stock dividend payouts are coming from value stocks or growth stocks, then there might be some reasons to reinvest instead of selling them.
Value stock and growth stock reinvestment
Value stocks and growth stocks anticipate long-term growth in the market. Typically, this strategy is a bet that average share values will increase over time. By the time investors are ready to liquidate their assets, each share should be worth more than before.
It is important to remember that markets are volatile, so reinvesting dividends can lead to merely breaking even on an investment, or possibly losing money in the event of an economic downturn. Economic downturns can happen at any time, which is why it is important to keep an eye on the news cycle.
How are dividends taxed?
If you received stock dividends during the course of a year, you may have to pay taxes on them.
Taxing long-term capital gains
Dividends are taxed as long-term capital gains, which is typically a lower rate than ordinary income taxes. There is a difference in tax rates depending on whether an asset offers a qualified dividend, also known as an ordinary dividend. When dealing with a nonqualified dividend payout, the tax rate could actually be higher than the rates of ordinary income taxes.
Company stocks held for more than 60 days from the last dividend payout generally would be classified as qualified dividend stocks.
Knowing what to do with your dividends can be confusing, so it is always best to research your alternatives.