stock dividends

How Stock Dividends Work

We receive a lot of questions from our readers regarding stock dividends and how they work. In particular, people want to know when they need to buy or sell a stock in order to be entitled to the dividend payment, and how much tax they will owe on it. Here are the answers and explanations for frequently asked questions about stock dividends:

Important Stock Dividend Dates and their Definitions

Declaration Date – This is the date that the board of directors of a company announces to shareholders, and the public, that the company will pay a dividend. At this time, the company will provide details of the other important dates, as well as the amount and nature of the dividend.

Ex-dividend Date – This date the stock trades without its dividend. If you buy a stock any time before the ex-dividend date, you will still get the dividend. However, if you buy it on or after the ex-dividend date, you won’t get the dividend. Alternatively, if you want to sell a stock and still receive a dividend that has been declared, you need to sell it on or after the ex-dividend date. The ex-dividend date is the second business day before the date of record. The reason for this is so that any trades in the stock have settled by the record date.

Record Date – This is the date that the company looks to see who are the shareholders of record. You must be listed as a shareholder of record on this date in order to be paid the dividend. In order to be listed as a shareholder of record on this date, you must have bought the stock prior to the ex-dividend date.

Payable Date – This is the date that the company sends out the dividend to all the shareholders of record. This date is generally a week or more after the date of record so that the company has adequate time to be sure everybody who is entitled to the dividend receives it.

Why “Buying Dividends” Doesn’t Work

Sometimes inexperienced stock traders will engage in what is known as “buying dividends”. This is where an investor will buy a stock after the declaration date, but prior to the ex-dividend date, and then sell it shortly thereafter. They do this to try and capture a “free” dividend payment. However, this strategy doesn’t work. It doesn’t work because everybody already knows the dividend will be paid, and the stock price will adjust in the market accordingly.

All things else being equal, the difference in the closing price of the stock the day before it goes ex-dividend, and the opening price on ex-dividend date will be equal to the amount of the dividend. As an example, if company XYZ declares a $2.00 per share dividend and the stock closes the day before the ex-dividend date at $50.00, it will open the next trading day (which is the ex-dividend date) at $48.00. Again, this is assuming all things being equal, so if there is news that would drive the stock $0.50 higher the next day, the stock will open at $48.50. Regardless, there was no free lunch on the dividend payment. A good rule of thumb in stock trading is that if something looks like a free lunch, it probably won’t work.

How Stock Dividends are Taxed

Dividends are usually paid in cash, but sometimes they’re paid in more shares of stock. For tax purposes, these two different forms of payment are the same. All ordinary dividends are taxed at your ordinary income tax rate. However, the IRS considers some dividend payments to be “Qualified Dividends”. If you have any qualified dividends, those are taxed as long-term capital gains, which is a much lower rate than your ordinary income rate.

The IRS defines qualified dividends by a series of criteria that can be confusing. The IRS criteria for qualified dividends includes that it must have been paid by a U.S. company or a foreign company that meets certain standards, held for a set period of time, and meet certain other requirements. However, you don’t need to worry about figuring out if your dividends are qualified, or not. When you receive your IRS form 1099-DIV from your broker, it will spell out for you how much of your dividends were ordinary, and how much were qualified.

We hope this answers your stock dividend questions. *We would like to point out that we are neither CPAs nor Tax Attorneys. Please consult a tax professional for their opinion on any complicated tax issues you may have.