Dividend Income vs. Ordinary Income
Dividends typically refer to payments from companies to their shareholders. They're essentially a way for companies that are doing well to share some of their profits with investors. You can also earn dividend income from funds such as mutual funds and index funds. Some dividend income is taxed the same as other income, like wages from working, but dividends known as qualified dividends are taxed at the long-term capital gains rate instead, which is usually lower.
How Dividends Work
When you own shares in a company, you are effectively a part owner of that business. That normally gives you the right to vote on who should serve on the company's board of directors and various other questions about how the company is run. It also gives you the ability to earn dividends if the company pays them out. Besides holding on to stock to sell for a higher price than you bought it for, receiving dividends is the main way to make money from the stock market.
When a company declares a dividend, it usually announces how much it will pay per share. For instance, a company might say that it will pay a $0.23 per share dividend. Stockholders are paid dividends in proportion to how many shares they own.
Some companies have multiple classes of stock, such as common stock bought and sold by most investors and preferred stock given to early investors. Different types of stock sometimes receive dividends at different rates. Mutual funds and index funds similarly pay dividends to their investors.
In some cases, companies will give additional shares of stock to shareholders rather than giving them actual cash. This is known as a stock dividend.
Understanding Dividend Yield
The ratio of the total cash dividends paid per year to the stock price is known as the dividend yield. It's usually written as a percentage. For example, if a stock valued at $5 pays out $1 in dividends over the course of a year, it's dividend yield is $1 / $5 = 0.2, or 20 percent. You can calculate dividend yield yourself by looking up a company's dividends and stock price, but you can also use a dividend income calculator tool online or see the dividend yield published by many brokerage sites and financial information sites.
Many longstanding companies with a steady rate of return, such as utility companies, are known for a predictable dividend yield that can generate more earning power than putting the same amount of money into the bank. On the other hand, there's more risk involved, since the money you put into a stock isn't insured the way bank deposits are insured by the Federal Deposit Insurance Corporation, and even a well-known company could see its fortunes change.
Companies that are expected to see continued growth may have lower dividend yields. That's not necessarily a bad thing, since it means they're continuing to put money into the company rather than paying it to investors.
Ordinary Income Vs. Dividends
Dividend income can either be taxed as ordinary income at your usual federal income tax bracket or at the long-term capital gains rate, which for most taxpayers is lower. It's generally either 0, 15 percent or 20 percent, and most taxpayers pay 15 percent.
Dividends taxed at that rate are known as qualified dividends. You can find out from a company's investor relations department or its filings with regulators whether its dividends qualify for the lower dividend income tax rate.
Some credit unions refer to the payments they make to account holders as dividends, since members are technically owners of the credit union, but this doesn't matter for tax purposes. Bank interest and dividend income from credit unions are both taxed as ordinary income.
Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.