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What is dividend income?
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What Is Dividend Income
Dividend income refers to a type of income originating from investing in stocks and equity securities in a company or corporation.
Dividends are sums of money corporations pay to their stockholders out of the profits they generate from their business operations.
For example, if you purchase shares of a bank in the stock market, the bank shares may provide you with a quarterly dividend payment.
We call this a “dividend stock” referring to shares of stock that pay dividends.
To better understand the stock dividend income, let’s break down the concept into its individual components: “dividend” and “income”.
Dividends refer to a payment or reward given to a company stockholder.
Corporations are legal entities that are owned by their shareholders (generally common shareholders).
As a separate entity, when corporations earn business revenues that exceed their costs, they generate a net profit (or have a positive net income).
Most of the corporation’s net profits are reinvested in the company to further its operations and grow.
However, companies that have generated a sufficient amount of money to fund their business operations can take a portion of their profits (or take money from their retained earnings) and pay a dividend to their stockholders.
A company may choose to pay dividends as a one-time payment or even on a recurring frequency, such as monthly, quarterly, semiannually, or yearly.
Income refers to the amount of money a person or legal entity receives from various sources.
According to Investopedia, income is defined as follows:
Income is money or the equivalent value that an individual or business receives, usually in exchange for providing a good or service or through investing capital.
Very broadly, we can classify income in three categories:
- Active income
- Passive income
- Portfolio income
Active income is when a person actively works on a job to earn an income or a business actively operations to generate revenues.
Passive income is a type of income that is earned without the material involvement of the beneficiary of the income, such as rental revenue from a real estate property.
Portfolio income is a type of income that is generated through investments, such as dividends, interest, and capital gains.
Dividend Income Definition
According to Investopedia, dividend income is defined as follows:
A dividend is a reward given to shareholders who have invested in a company’s equity, usually originating from the company’s net profits.
As you can see from this definition, ordinary dividend income means:
- A reward
- Given to shareholders
- Having invested in equity securities
- Coming from the company’s net profits
Types of Dividends
Are there different types of dividends?
Dividends can be paid out to stockholders as an ordinary dividend, special dividend, or stock dividend.
An ordinary dividend is regularly scheduled payments issued to stockholders paid out of a company’s retained earnings (earnings that were not reinvested back into the company).
Companies that are listed in the stock market (publicly traded companies) will issue ordinary dividends once a quarter or once a year.
You may have heard of the phrases “quarterly dividends” or “yearly dividends”.
The key feature of an ordinary dividend is that it is expected to be paid at a predetermined schedule.
A special dividend is a type of dividend that is paid on a one-time basis.
In other words, the special dividend is a non-recurring distribution of assets to the stockholders.
A company that typically does not declare dividends to its stockholders may choose to declare a one-time special dividend to pay out some of the earnings from the company’s retained earnings.
You may see public companies provide a special dividend to their stockholders or, more often, private companies.
Special dividends may be paid if the company has experienced particularly strong earnings during the period or intends to make changes to its financial structure.
A stock dividend is a type of dividend that is paid to the shareholders of a company by issuing additional shares of stock instead of cash.
In other words, a company paying stock dividends will issue additional shares to all the eligible shareholders of the company.
By issuing additional shares to a company, the stock dividends dilute the stock price.
A company may issue stock dividends to its shareholders to compensate them but without using its available cash to pay out cash dividends.
Stockholders receiving stock dividends will also see a tax advantage as they are generally not subject to any taxes when they are issued but only when the stock dividends are sold.
Taxable Dividend Income
Is dividend income taxable?
Dividend income is taxed depending on the type of dividend that you may have received.
The tax treatment of ordinary dividends (or unqualified dividends) or qualified dividends are different.
Qualified dividends are taxed under the capital gains tax rates (that is generally lower than the income tax rates).
In essence, in the United States, the IRS taxes qualified dividends as capital gains and not as ordinary income.
For dividends to be “qualified”, they must meet the IRS requirements to be eligible for a lower tax rate, such as:
- The paying company must be a US corporation or a qualified foreign corporation
- The stockholder must hold the stock for more than 60 days during the 121-day period starting 60 days before the ex-dividend date
As you can see, it can get a bit complicated but a “qualified dividend” qualifies for a lower tax rate and is taxed as capital gains.
Most of the stock dividends are taxed as capital gains or qualified dividends.
Ordinary dividends are taxed under the personal income tax rate.
All ordinary dividends are taxed as an income (such as special dividends or recuring dividends).
In other words, if you invest in dividend stocks and receive cash dividends, you will have to report that the dividend income on your personal income tax and pay ordinary income tax.
It’s important to note that not all distributions made by a company may be taxed as “dividend income”.
You have special cases where you may be taxed differently, such as in the following cases:
- Return of capital
- Capital gain distributions
- Stock dividends
The return of capital is when the company pays back the investor’s investment.
Capital gain distributions are possible by entities such as mutual funds, exchange-traded funds, money market funds, and real estate investment trusts who are able to pay their capital gains to their stockholders.
A spinoff is when a company spins off a division or an entity it owns by issuing stock dividends to the shareholders of the company.
A stock dividend is when a company issues additional shares to the existing shareholders to compensate them but without having to use its cash reserves.
Dividend Income Example
Let’s look at an example of dividend income to better illustrate the concept.
According to the IRS (the Internal Revenue Service) in the United States, a dividend income represents any distribution (in cash or in property) made by a corporation to its shareholders.
Imagine that you purchase shares in a publicly traded company that regularly pays dividends.
You look at the company’s income statement and balance sheet and find out that:
- The company has generated $5,000,000 in net profits during this period
- The company is planning to reinvest $4,500,000 back into its business
- This has left the company with $500,000 in extra cash as retained earnings
The company decides to pay the $500,000 as dividends to its stockholders.
Since the company has 500,000 common shares outstanding, it will therefore issue $1.00 of dividend per share.
As a result, you will receive a dividend income of $1.00 per share on the stocks you hold.
Dividend Income vs Interest Income
What is the difference between dividend income and interest income?
According to the Corporate Finance Institute, interest income is defined as follows:
Interest income is the amount paid to an entity for lending its money or letting another entity use its funds.
In other words, you earn an interest income when you lend money and earn a return on your investment or principal.
Essentially, someone pays you “interest” to compensate you for letting them use your money.
When you receive interest, you will then report that as interest income.
On the other hand, dividend income is an amount of money that you receive as a stockholder of a corporation that has declared to pay you dividends.
If you have invested in common stocks, you are only eligible to receive dividends when the company’s board of directors declares dividends.
If you invested in preferred stocks, then the corporation is obligated to pay you dividends as per the characteristics of the preferred stock.
A dividend comes out of a company’s profits or retained earnings.
For a company, interests are expenses that can be used to reduce a company’s tax liability.
However, dividends are not tax-deductible for companies as they come out of a company’s “net profit” or retained earnings (after the company has paid the applicable taxes on its business income).
Dividend Income vs Capital Gain
What is the difference between dividend income and capital gain?
A dividend income is a sum of money paid out by corporations to their stockholders in a given period originating from their business profits.
When a dividend is paid, the stockholder will be taxed in the same tax year as the year the dividend revenue was earned.
In most cases, dividends are taxed as ordinary income (although there are exceptions).
On the other hand, a capital gain is essential the “gain” on your “capital”.
Your capital refers to your initial investment.
For example, if you invested $10,000 to buy the stocks of a corporation, your initial capital investment is $10,000.
If you eventually sell the same stocks for a total of $15,000, you then have a $5,000 capital gain to report and pay taxes on.
Unlike dividends, you do not pay taxes when you make a capital investment and for the entire time you hold on to your investment.
When you liquidate your investment, if you realize a profit you will then need to pay capital gain taxes on your profit.
Dividend Income Takeaways
So, what does dividend income mean?
Is dividend income an ordinary income?
Is dividend income taxable?
In this article, we’ve broken down the notion of dividend income so you understand what it means and how it works.
Dividend income is income that you earn by investing in the stocks of a corporation such as common shares or preferred shares.
A company pays dividends to its shareholders out of its net profits generated in a given period or out of its retained earnings account.
For the stockholder receiving the dividends, in most cases, it will be reported as ordinary income on its personal income tax report.
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