While investing in stocks has proven to be the easiest and best way for the average investor to build long-term wealth, owning stocks that pay dividends is an often-overlooked way to help achieve that goal.

A dividend is a distribution of a portion of a company's earnings. Knowing how dividends work, you can own these types of stocks to your long-term advantage. Here's what you need to know about dividend-paying stocks.

A person reaching out their hand to receive a check.

Image source: Getty Images.

Definition of a dividend

Companies can choose to regularly reward their shareholders by paying dividends, usually in cash, or, rarely, in stock. Companies that consistently generate more profits than management can efficiently reinvest in the business often choose to start paying dividends.

Companies typically pay one of three types of dividends:

  1. Regular dividend: This type is the most common. Companies that pay a regular dividend generally pay them consistently over time, in part by calibrating the amount of the dividend to ensure it's affordable in both good and bad years. Regular dividends are usually paid quarterly, although they can also be paid monthly, biannually, or annually.
  2. Special dividend: This type of dividend is a one-time payment. A company might choose to pay a special dividend after a string of highly profitable quarters or because the company sold an asset and doesn't have an immediate use for the money. Some companies pay special dividends because they have accumulated cash over time that the business doesn't need to sustain its operations. Companies often publicly announce special dividends to tell the market they plan to send cash to shareholders but that shareholders should not expect the payment to become a recurring event.
  3. Variable dividend: Companies that produce commodities such as oil and gas or timber sometimes opt to pay a variable dividend in addition to regular dividend payments. Variable dividends tend to be paid at fairly consistent intervals but vary in amount depending on a company's earnings in the prior quarter or year.

Companies that pay dividends are evaluated on the value of annual dividends paid relative to the price of the company's stock, which is known as the company's dividend yield. A stock that pays yearly dividends of $0.50 per share and trades for $10 per share has 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 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 do companies pay dividends?

Not all companies pay dividends, but many do. Roughly 75% of companies in the S&P 500 (SNPINDEX:^GSPC) pay a regular dividend.

Larger and slower-growing businesses are more likely to pay dividends to their investors than smaller, faster-growing companies. Growing businesses need to retain their earnings to continue to grow, while large, established companies are already profitable. Most companies with plenty of available cash choose to pay a dividend.

How are dividend amounts determined?

Companies that pay dividends tend to develop a dividend policy over time, which guides how much to pay out to shareholders. The amount of a company's dividend each quarter is voted on and must be approved by the company's board of directors. 

When are dividends paid?

Most companies that pay a regular dividend do so quarterly. After the board of directors agrees on the amount of a dividend payment, the company officially declares -- announces -- its next dividend. This day is known as the declaration date.

On the declaration date, the company also indicates a date, known as the record date, on which you must be a shareholder in the company in order to receive the declared dividend payment. The establishment of the record date in turn sets the ex-dividend date, which is the first day that shareholders purchasing the stock are not eligible to receive the declared dividend. The ex-dividend date occurs one business day before the record date.

The payment date is the date on which the dividend payment is actually disbursed to shareholders. If a shareholder is receiving a dividend by mail, dividend checks are mailed on the payment date.

How are dividends taxed?

If you own dividend-paying stocks in a taxable brokerage account, the dividends you receive are taxed as either ordinary income or qualified dividends. Dividends that are "qualified" are taxed at lower, long-term capital gains rates. 

If you own the dividend stock in a tax-advantaged account, you are not taxed on dividends received. These are some of the account types that exempt you from paying taxes on dividends, provided you do not withdraw money from the account:

Dividend examples

Here's an example of a recent dividend payment by Federal Realty Trust (NYSE:FRT), a real estate investment trust (REIT). This company, which pays a quarterly dividend, paid $1.06 per share to stockholders in early 2021. Federal Realty Trust has increased its regular quarterly dividend in each of the past 53 years, qualifying it as both a Dividend Aristocrat and a Dividend King.     

As a more complicated example, oil and gas producer Devon Energy (NYSE:DVN) has paid several types of dividends in recent years:

  • The company pays a regular quarterly dividend of $0.11 per share, which is set at that rate because it's sustainable for the company to maintain even when energy prices are low.
  • Devon paid a special dividend of $100 million, or $0.26 per share, to its investors in late 2020, following a $300 million sale of oil and gas assets.
  • The energy company launched an industry-first variable dividend program in early 2021. It paid a variable dividend of $0.19 per share in the first quarter, followed by a $0.23-per-share variable payment in the second quarter.

While dividend payouts can be routine or circumstance-specific, a company's aim in making dividend payments is usually always the same -- to return to shareholders any excess profits that are not needed for the business.