One of the ways investments pay a return is through the distribution of dividends, which are actually portions of net profit being returned to the owners, or shareholders, of a corporation. The percentage of total profits paid out is determined by a company’s board of directors, which are elected by shareholders and are therefore directly accountable to them.
Once in a while, especially in utility companies which depend on a reliable source of new investment capital, companies will elect to pay out dividends even when no profits have been earned. This is called return of capital, and is not taxable as regular income, as dividends are, but rather, are treated as a return of capital.
What To Do With Your Dividends
In either case, if you own stocks that pay out quarterly dividends, you have options for how to accept and handle those funds. You can get your dividends by check, or, if your stock is being held by your brokerage firm, have that money deposited into your investment account for subsequent disposition, either as cash or to use for further investment.
Some companies pay a stock dividend instead of cash, in which case the decision has been made for you, the outcome of which is nearly identical to what is described below.
One of the most common ways to handle dividends, though, is through participation in a dividend reinvestment plan. This is a program offered by a company wherein dividends are automatically reinvested in more shares of the company’s stock using the price at the time of payout.
Compounding Is Your Friend
This is similar in nature to how banks pay compound interest – if you don’t withdraw it, this new money also earns interest and, over time, your return compounds beyond what you’d have received had you withdrawn the funds.
Where stocks are concerned, each time you reinvest your dividend you end up owning even more stock, which means the next payout (provided the dividend isn’t lowered) will result in an even greater amount to be reinvested.
DRIPs – They’re Everywhere
Mutual funds offer dividend reinvestment programs (DRIPs), as do other programs such as 401Ks, IRAs, and certain brokerage accounts.
If you’re investing for the long term, a dividend reinvestment feature is one of the most promising strategies you can incorporate into your approach. But like any element of investing, everything depends on choosing the right company to invest in, and their dividend payout history, along with future prospects, is one of the critical variables you need to consider in that decision.
