It’s no secret that people constantly seek ways to earn a passive income.
Some dabble with writing a book, while others use the oldest trick in the book – real estate investment. There’s another passive income type that everyone wants to partake in, but the complexities surrounding it prevent them from doing so.
We’re talking about a dividend.
A dividend is how a company distributes a portion of its earnings to shareholders. Typically, the organization’s shareholders decide who gets what. And we’ll get to that in our future blogs – today, our objective is to help you understand the two ways through which companies issue dividends:
- Cash Dividend
- Stock Dividend
Both can produce a regular income stream for you, but how they work differs. And learning about the differences is essential, especially if you hope to make money through dividends.
We’re writing the blog for the precise reason – to strengthen your grasp on cash and stock dividends.
Stock Dividend Vs Cash Dividend
What Is a Cash Dividend?
In most cases, if you hear a company use the word ‘dividend,’ it’s referring to a cash dividend. It’s when an organization distributes dividends by handing out cash on a per-share basis. According to a per-share basis, shareholders receive a fixed amount of money depending on each share they own.
Let’s understand this with the help of an example.
Sharon owns 100 shares of a company called The Winter Soldier, which pays a cash dividend of $0.15 per share. So, when the time to hand out the cash dividend comes, Sharon will receive $15 from The Winter Soldier.
This also produces an impact on The Winter Soldier. Since its capital was transferred to Sharon, the company’s share price will drop by $0.15.
If we talk about real organizations and not fictional ones, like The Winter Soldier, they pay a set dividend amount each quarter.
According to the Internal Revenue Service (IRS), cash dividends are income, meaning the shareholders may have to pay taxes. Even reinvesting the amount doesn’t exclude them from incurring tax.
That said, you’ll have to pay a lower tax on qualified dividends than non-qualified dividends. If you wish to qualify for a reduced tax rate, know that you must’ve owned the asset for over 60 days.
What Is a Stock Dividend?
When shareholders stay invested in a company, they’re provided a bonus in the form of a stock dividend.
Unlike a cash dividend, a stock dividend doesn’t offer immediate financial incentives. Instead, it increases a shareholder’s stake in a company by giving them more shares.
Similar to a cash dividend, a stock dividend impacts a company’s stock price.
Let’s go back to the example of The Winter Soldier.
Assume it has a market capitalization of $1 billion and 10 million outstanding shares. So, if the company issues a 10% stock dividend, the shares will increase by 1 million.
However, this would have no impact on The Winter Soldier’s Value.
Once a shareholder receives a stock dividend, they have the option of retaining or selling it at the current price.
As far as the IRS’s treatment of high stock dividends is concerned, the government agency doesn’t tax it – and they have a solid reason for not doing so.
When a stock dividend is issued, there’s no value in transfer, nor do the investors gain anything. It’ll only be considered worth taxing if the investors sell it.
Of the two types, a cash dividend is the most commonly used, and a stock dividend is issued by a company running short of cash. This way, it can feed two birds with one scone – earn additional income and satisfy shareholders.
Stock Dividend vs Cash Dividend – The Major Differences
Until now, we’ve provided general information about cash and stock dividend. But if you want to invest in either, we’ll have to dig deeper.
Therefore, to help you make a decision worth your time and energy, we’ve discussed the major difference between both below:
1. The Option to Sell
The most notable difference between a stock dividend and a cash dividend is the choice of selling them whenever the investor wants. For instance, if you purchase a stock dividend, you can sell it to generate money. A cash dividend doesn’t give you this option. If you purchase one, you’ll have to make do with what’s given to you without asking for an additional ownership stake in the company.
2. The Duration of Ownership
When investors purchase a cash dividend, it’s for the short term. This means in less than a year, they hope to sell the cash dividend and earn money. In the case of a stock dividend, the investors’ intentions are different. They are in it for the long run and continuously monitor the share price. When the company they’ve invested in makes a profit, the shareholders earn a portion.
The Risk Association
The Risk AssociationWe mentioned in the last point that those who invest in a cash dividend have short-term goals. Because of this, the risk associated with their venture is also low. On the other hand, the risk factor is high in a stock dividend. And it’s because the investors’ profit or loss is tied to how the stock will perform in the future. The rising interest rate may also affect a stock dividend.
A Cash Dividend Is Better for You If You…
- Want to earn a regular income
- Need risk-free dividends
- Do not plan on investing in a company for the long term
- Wish not to be bound by one income stream
A Stock Divided Is Good for You If You…
- Wish to grow your investment portfolio
- Believe that the company you’ve invested in will experience significant growth
- Are looking for an investment opportunity for the long term
- Do not need cash urgently
Dividends – The Advantages and Disadvantages
Like every financial investment type, dividend investment has its fair share of pros and cons. And you must learn them if you want to turn your venture profitable.
Advantages of a Dividend
It Creates a Passive Income Stream
The biggest appeal of dividend investing is that it creates a passive income stream. What’s even more interesting is that it requires little to no work. Of course, the company you’re investing in should continue making a profit so that you can get your share of the income, but that’s beside the point.
It Maximizes Your Returns
Many studies have proved that dividend-paying stocks make it through recessions or bear markets (when stocks fall by 20% or more for a long period). In fact, dividends’ ability to outperform recessions is why many investors prefer to invest in them.
It Can Be Reinvested
After receiving a dividend, mainly a cash dividend, you have the option to use the amount for your personal expense or reinvest it. And frequent reinvesting means increasing your chances of earning a high profit steadily.
Disadvantages of a Dividend
It Increases Taxation Frequency
The major disadvantage of dividend investing is that you’ll be taxed twice – once before you receive a dividend and the second when you pay personal tax on your income. This means you’ll have to pay tax as an owner of the company and individually.
It Is Tied to the Company’s Performance
You can only profit off a dividend if the company whose shares you’ve purchased does well in the short- or long-term. Otherwise, you won’t be eligible to earn a penny, a significant disadvantage of dividend investing.
It Doesn’t Guarantee Returns
The stock market is volatile, and companies can stop issuing dividends anytime. Although it’s not common, organizations may take this step to respond to market changes or pay large unforeseen expenses.
The Ball’s in Your Court
Now that you’ve learned the differences between a stock and a cash dividend, it’ll be easier for you to invest in one. But before you do, consider its impact on your financial condition. You should only proceed if you’ve got the capital to bounce back if things go sideways.
And if you can’t figure out the stuff yourself, let American Made llc know. Using our experience and knowledge, we’ll guide you to a better dividend based on your financial condition, the payout ratio, the company’s future, and other factors.
Frequently Asked Questions (FAQs)
No, a stock dividend is not the same as a cash dividend. The former is a bonus compensation companies provide to shareholders for retaining their investment. The latter is when an organization that makes a profit shares a portion with the shareholders.
The stocks of the following companies pay the highest dividends: AbbVie, AT&T Inc., Chevron, Walgreens Boots Alliance, and more. It’s important to mention that the highest dividend-paying companies change every month, if not daily.
There’s no simple answer to this question. The better dividend depends on what you hope to make from your investment and when. For example, a cash dividend provides instant financial incentives, while a stock dividend proves beneficial in the long run.
Dividend per share (DPS) is the portion of earnings that shareholders receive. To calculate DPS, divide the total number of dividends by the total number of shares.