One way investors profit from stocks is when the share price exceeds what they paid for it. Of course, this is a paper profit until the stock is actually sold and can be lost if the stock price goes down. Shareholders can also make a more regular and predictable profit on stocks that pay dividends. Many companies give shareholders the option of taking dividends in cash or having them reinvested to buy additional shares of stock.
Dividends are the portion of a corporation's earnings that its board of directors elects to pay to shareholders. Companies calculate dividends as a percentage of the stock's share price, and they are paid to shareholders in the form of a specific dollar (or cent) amount per share. Dividends are normally declared and issued on a quarterly basis, although smaller companies may pay them annually. Companies typically pay dividends as a means of rewarding shareholders, although they are under no obligation to do so. The company's ability to pay dividends is used by financial analysts, potential investors and current shareholders as one measurement of its overall financial health.
Reinvesting the dividends instead of receiving cash can be an effective long-term strategy, particularly if you don't have the need for immediate income. As you accumulate shares over time, the value of your portfolio can increase without the need to supply additional funds out of your own pocket. Many companies allow you to set up a dividend reinvestment plan, or DRIP, where dividends are automatically used to purchase more shares for you. Some companies may also allow you to do a partial DRIP, where some of your dividends are used to purchase additional shares while the rest are sent to you in cash.
Receiving dividends in cash can be advantageous for those who need the additional income, such as a retiree who no longer has the benefit of a regular paycheck. Taking the cash also offers greater investment flexibility, as you can invest the money in vehicles of your choosing. If you lack confidence in the company's financial future, or you need or want to reduce your investment risk, you could take the dividends as cash and reinvest them in fixed income vehicles like bonds or CDs.
Whether you take the dividends in cash or reinvest them to purchase more of the company's stock, as long as the distribution amount is $10.00 or greater, you typically need to pay taxes on dividends for the tax year in which they are declared . The company will send you a Form 1099-DIV at the end of the year that should include a detailed breakdown showing how the company calculated the distribution amount.