Dividend Myths Foolishly Debunked, Part 1

While researching a Fast and Foolish article on TD AmeriTrade Holding Corp. (Nasdaq: AMTD  ) , I realized something: A lot of people have no idea, or the wrong idea, about what happens when a company pays its dividend, and what they can do about it. I've boiled these misunderstandings and misconceptions down to seven myths.

In Part 1, we'll look at myths dealing with price adjustments, taxes, and trusting your 1099-DIV form. Read on to start becoming a Foolish dividend expert.

Myth one: Stock prices do not adjust downward when dividends are paid.
Run for the hills -- Ameritrade opened 25% down from the previous close! Oh, wait -- they only went ex-div on a special dividend. Come back!

That might have been the scene for some investors the morning of Jan. 25. One of the important dates in a dividend cycle is the "ex-dividend" date (often abbreviated "ex-div"). According to the IRS, this is the date upon which a new buyer of a stock will not receive a dividend payment. On that day, the money no longer belongs to the company, and new shareholders cannot get it, so the exchanges artificially lower the stock price by the amount of the dividend to reflect the price available to new purchasers.

In most cases, since dividends are small compared to the daily fluctuations in stock price, this adjustment is lost in normal trading noise. Sometimes, though, the dividend is much larger than normal movement levels, and the price drop is highly apparent. When it opened Jan. 25, Ameritrade's price had fallen $6.44 below the previous closing price. Part of that was normal trading movement, but the vast majority of it was due to the $6 dividend.

Myth two: Only the stock price is adjusted.
Nope. Limit orders (buy or sell) are also adjusted downward. Options are another beast entirely, but they are also revalued.

Limit orders -- an order to buy or sell a stock at a specified price or better -- are usually automatically adjusted downward on the ex-dividend date, just like the stock price. This prevents an artificial triggering of the order if the limit is set slightly below the market price of the stock before its ex-dividend adjustment kicks in. However, some brokers allow customers to add a Do Not Reduce (DNR) qualifier, preventing this adjustment.

For instance, suppose you set a limit order to buy 100 shares of XYZ Corporation at $15 before the ex-dividend date. The company pays a $0.25-per-share dividend before your order is filled. On the ex-dividend date, your limit order will change to 100 shares at $14.75. If you use a DNR qualifier, though, the limit price remains at $15.

Not all exchanges make this automatic adjustment, however. One example is the Toronto stock exchange (TSX).

The situation with option pricing is quite a bit more complicated. It depends on what pricing model is used, whether it's a call or put, whether you are buying or selling, and whether the option is American or foreign. One complication: It may or may not be best to exercise the option just before the ex-dividend date. Here is one Foolish discussion board post recommending several different option-pricing books that cover this hairy topic.

Myth three: All dividends are taxed at the special lower rate.
Wouldn't that be nice? In truth, you have to hold the stock for a certain amount of time surrounding the ex-div date to benefit. The IRS requires you to hold the stock for at least 60 consecutive days within a 121-day larger window, spanning 60 days before and after the ex-dividend date.

To return to our Ameritrade example, 60 days before the Jan. 25 ex-dividend date was Nov 26. So, if you wanted to ensure that the dividend qualified for a lower 5% or 15% rate, depending on your normal tax rate, you had to have held Ameritrade's stock for at least 60 days sometime between Nov. 26 and Mar. 24. Otherwise, the dividend would be taxed as regular income.

There's a wrinkle, of course: You cannot count the day you bought the stock as one of the 60. Don't be caught short: Make sure you hold the stock long enough to meet the rules for the lower "qualifying" dividend tax rate.

Myth four: Everything is reported to you correctly on the 1099-DIV form.
You wish. This ties into Myth 3, especially the "qualified" part.

On your 1099-DIV form, dividends are reported in two boxes. Box 1a lists total dividends paid to you from a particular source -- the company sending you the form, often your broker. Box 1b lists the amount of dividends which qualify for the lower tax rate. However, if it is impractical for the company to determine whether you held the shares long enough for them to become qualified, then the entirety of the dividends will be reported in Box 1b as if they all were qualified.

In short, if you sell the stock before the 60-day holding period is up, it's your responsibility to report that money as "non-qualifying."

That covers four of the seven myths. Part 2 will discuss the remaining three, so be sure to come back for more debunking.

For more Foolish know-how, check out our Tax Strategies and Investing for Income message boards.

Get paid to invest! LetMotley Fool Income Investorlead you to stocks with solid growth potential and dynamic dividends. Sign up today for a free 30-day trial.

Foolish contributor Jim Mueller loves it when a company gives him some of its profits. It's almost like free money! He is a customer of Ameritrade, but not a shareholder, so he missed that special dividend. The Fool has an ironclad disclosure policy.


Read/Post Comments (0) | Recommend This Article (18)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 502072, ~/Articles/ArticleHandler.aspx, 12/18/2014 5:33:14 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement