Investing in stocks has proven the easiest and best way for the average investor to build long-term wealth. And it's not just a way to make money by owning companies that get bigger and more profitable -- dividends are an often overlooked way to build wealth. 

Dividends are a distribution of a portion of a company's earnings that it doesn't retain for business purposes. Owning dividend stocks can help you be more successful, build greater wealth, and focus on your long-term wealth building and financial goals instead of short-term stock market movements. 

Jar full of coins being poured out.

Image source: Getty Images.

What is a dividend?

A dividend, as described above, happens when a company sends money (or, very rarely, stock) to its shareholders. When a company gets to the point that it consistently earns more than management can effectively reinvest in the business, establishing a dividend policy and sending those excess profits back to investors is a smart move. 

Dividends generally come in two types:

  1. Regular dividends: These are dividends that a company generally expects to pay consistently over time as part of its recurring earnings. Most companies try to pay a regular dividend that they know they'll be able to pay in both good and bad years. Regular dividends are typically paid quarterly (once every three months).
  2. Special dividends: These are dividends that you can consider "one-off" payments. A company might pay a special dividend after a string of highly profitable quarters. In some cases, a company will pay a special dividend because it sold off an asset and doesn't have an immediate use for the money. Some companies also pay special dividends because they have accumulated cash over time that the business does not need to sustain its operations. Companies often announce special dividends to tell the market that they plan to send cash to shareholders, but that shareholders should not expect the dividend to be a recurring event.

Investors look at dividends relative to the price of a company's shares. Investors divide the total amount a company pays in dividends per year by the price of the stock to arrive at what's known as a dividend yield. So a stock that pays annual dividends of $0.50 per share and trades for $10 per share would have a dividend yield of 5%.

Dividend yields enable investors to quickly gauge how much they could earn in dividends by investing a certain amount of money in a stock. If a stock has a yield of 5%, you know that you would earn $5 on every $100 invested, $50 on every $1,000 invested, and so on. A dividend yield also allows you to compare a stock to other income investments, such as bank CDs or bonds.

Why companies pay dividends

Not all companies pay dividends, but a large percentage of them do. Roughly 75% of stocks in the S&P 500 Index (SNPINDEX:^GSPC) pay a dividend.

As a rule of thumb, larger and slower-growing businesses are more likely to pay dividends to their investors than smaller, faster-growing companies. This is because growing businesses need to retain their earnings to invest in more facilities, stores, employees, and so on to grow. Very few businesses can grow without investing more money back into the business.

How dividends are determined

Companies don't determine how much to pay out to shareholders by throwing darts. Instead they tend to develop what's known as a "dividend policy" over time. A dividend policy is usually an implicit or explicit goal, set by a company's board of directors, to pay out a certain amount of income as a dividend over time. 

When and how dividends are paid

Dividends are declared and paid on a per-share basis, with most companies that pay a regular dividend doing it quarterly. There are some exceptions, including a few that pay a dividend every month, but the vast majority of dividend stocks pay in this manner. 

Dividend-paying companies generally declare dividends -- meaning the board of directors officially announces the next dividend payment -- weeks in advance of actually paying them. There are several dividend dates you need to know:

  • Declaration date: This is the day a company officially announces that its board of directors has decided to make a dividend payment in the future.
  • Payment date: This is the date on which a dividend payment is actually made to shareholders. The payment date is when dividend checks are mailed, or when the payment should show up in your brokerage account (though it may not show up exactly on that date.)
  • Record date: This is the date on which you must be an official owner of a stock to receive the declared dividend payment.
  • Ex-dividend date: This is the day on which the stock trades "ex-dividends," or without the dividend payment in question. The ex-dividend date is one business day before the record date. Thus, to receive a dividend, you must have owned it the business day before the ex-dividend date.

In the rare case of a dividend that is paid in shares, investors counting on dividends for income will need to factor in a few extra days to get their hands on cash. You will need to sell the shares awarded as dividends, then wait a couple of days for that trade to "settle" before you can transfer the cash proceeds out of your brokerage account. 

How dividends are taxed

Dividends are indeed considered taxable income, unless you own the dividend-paying stock in a tax-advantaged account. Here are some of the kinds of accounts with which you won't have to pay taxes on your dividends:

This isn't an exhaustive list, but in short, these accounts are structured to allow you to maximize the growth of your investments without owing any tax so long as you don't take a distribution out of the account.

Now to the meat of the question: How are dividends taxed? 

If you own dividend stocks in a taxable brokerage, dividends are generally taxed as either regular income or long-term capital gains, depending on whether the dividend is considered a "qualified dividend" (meaning it qualifies for the lower capital gains rate) or not. 

There are also distributions that have different tax implications, including a "return of capital" that isn't a dividend, but a portion of your capital investment sent back by the company. A return of capital is not taxable since it's the company sending back part of what it got from investors, but it could create future tax implications. It lowers the cost basis of your stock purchase by the amount you were paid per share, which could increase capital gains if you sell those shares for a profit in the future. 

Investing in dividend stocks

Investors who are new to dividend investing often start with dividend aristocrats -- stocks in the S&P 500 Index that have paid dividends and increased them for 25 consecutive years or more. Few businesses have even paid a dividend for 25 years in a row; even fewer have increased their dividends in every single year for that long or longer.

Selected Dividend Aristocrat

Years of Dividend Growth

Johnson & Johnson (NYSE:JNJ)

57

Procter & Gamble (NYSE:PG)

57

Target (NYSE:TGT)

48

Nucor (NYSE:NUE)

46

Realty Income Corporation (NYSE:O)

25

The list above includes some of the 66 (as of Sept. 2020) Dividend Aristocrats on the market today, so it's just a sampling of the businesses that make the cut. But these businesses are a good representation of the kinds of companies that have durable business models that enable them to sustain -- and increase -- their dividends over time.