Companies can pay shareholders stock dividends in the form of either cash or stock and investors can receive stock dividends in both non-retirement and retirement accounts.

Because dividends have been shown to improve long term returns, investing in dividend paying companies has become increasingly attractive. Read on to learn more about cash and stock dividends, their tax consequences, and whether or not dividend paying stocks are right for you.

Types of stock dividends

A cash dividend may be paid to investors to reduce excess cash on the balance sheet that can't be otherwise invested in the company for growth.

If a company wants to preserve cash for investment or give shareholders a tax free dividend, they may pay investors a stock dividend, rather than a cash dividend.

Typically, mature companies pay cash dividends when they create more cash than required to fund their operations while stock dividends are paid by both young and mature companies to reduce share prices and encourage new investors to become shareholders.

Here's how they work

Regardless of whether a dividend is paid in cash or stock, dividends reduce a company's share price by an equivalent amount to the dividend that is paid.

For example, if XYZ Corporation pays a $0.50 quarterly cash dividend, then XYZ will pay an investor $0.50 for each share the investor owns on a date that is specified each quarter. If a person owns 100 shares, then that investor would receive a $50 dividend payment, which the investor can then use as income or invest.

In this case, if XYZ's shares are trading at $100, then a $0.50 cash dividend payout reduces the company's share price by $0.50 to $99.50

If XYZ chooses to pay a two-for-one stock dividend instead of a cash dividend, then an investor owning 100 shares of a company will receive 100 additional shares on a specific date. Once that two-for-one dividend is paid, XYZ's $100 share price will be halved to $50.

In both instances, the important take-away is that the total value of an investors position in XYZ, plus any cash dividend received, will be unchanged from what it would otherwise have been on the day the dividend is paid.

The nitty gritty

If you're paid a cash dividend by a company in a non-retirement account it will create a taxable event in the year during which it is paid.

A cash dividend can be categorized as non-qualified or qualified and each is taxed differently.

Qualified dividends are paid by U.S. companies to shareholders that have owned shares for more than 60 days of the 120 day period beginning 60 days prior to the ex-dividend date. Preferred dividends are considered qualified if preferred stock is owned for more than 90 days of the 180 day holding period beginning 90 days prior to the ex-dividend date.

If the shareholder is in the 10% and 15% tax bracket, then qualified dividends are tax free. If the shareholder is in a higher tax bracket, then qualified dividends can be taxed at rates as high as 20% for high income earners.

If cash dividends are non-qualified, then they are taxed at ordinary income tax rates up to the current maximum 39.6% rate.

Unlike qualified and non-qualified cash dividends, dividends that are paid in the form of stock rather than cash are usually tax free. However, if an investor sells the shares received as a stock dividend, then capital gains taxes could apply.

Because of the tax implications of cash dividends, owning cash dividend paying companies in retirement accounts may make sense because retirement accounts allow investors to delay paying tax on their cash dividends, which allows for more money to remain invested.

Oh, and don't forget...

Cash dividends provide income, but if you're not relying on dividend income to live on, reinvesting cash dividends can lead to a higher portfolio value over time because historically, equity markets have generated greater returns than cash.

Also, although stock dividends are tax free most of the time, if a company offers a cash dividend option to the stock dividend, then it will be taxed, so make sure you pay attention to the fine print or consult with your accountant if you're unsure. 

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