Most people are familiar with the concept of a cash dividend, where companies pay out a portion of their earnings to shareholders, but stock dividends can be a little more foreign. As companies consider stock dividends as a way to address liquidity issues during the COVID-19 environment, investors should keep these differences in mind.
Let’s take a look at how both cash and stock dividends work and some important factors for investors to keep in mind when receiving them.
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What Are Cash Dividends?
Cash dividends occur when companies pay shareholders a portion of their earnings in cash. When this happens, the company’s share price drops by roughly the same amount as the dividend amount, since the economic value is simply transferring from the company to shareholders instead of being reinvested in the company.
Most companies pay a set dividend each quarter with a dividend yield that’s expressed as a percentage of the share price. For example, Union Pacific Corp. (UNP) pays a dividend of $3.88 per year per share. The $150 share price means that the dividend represents a 2.55% dividend yield—a metric that can be easily compared between companies.
The IRS treats cash dividends as income and shareholders may have to pay tax on them even if they’re reinvested, although qualified dividends are subject to lower capital gains tax rates than non-qualified dividends. The only exception are dividends that are accrued in tax-advantaged retirement accounts like Roth IRAs.
What Are Stock Dividends?
Stock dividends occur when companies issue new shares and distribute them to existing shareholders. When this happens, the company’s share price drops to reflect the impact of the dilution of the existing shares outstanding. Shareholders can either keep the new shares or sell them to create their own cash dividend.
Many companies with little liquidity (e.g. cash and equivalents) use stock dividends to reward shareholders or issue dividends which are a mix of stock and cash. These have become more common amid the COVID-19 crisis. For example, Macerich Co. (MAC) recently announced a $0.50 per share quarterly dividend payable in 20% cash and 80% common stock.
The IRS doesn’t generally tax stock dividends unless shareholders have the option of taking a partial or full cash dividend – even if they opt for a stock dividend. After all, there is no value transfer occurring with stock dividends, and investors have experienced no gains unless they sell stock. It’s just an accounting change in the number of outstanding shares.
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Implications for Investors
Dividends shouldn’t impact the value of a stock – they are simply different types of value – but they can impact an investor’s perception and tax liability.
Cash dividends involve converting a portion of equity into cash on behalf of shareholders. The total value of the company (e.g. the value of your stock plus dividend) isn’t higher than the value of the stock prior to the transaction, but shareholders receive an income without selling stock. Of course, the income is subject to immediate tax.
Stock dividends involve increasing the number of outstanding shares. The total value of the company isn’t higher than the value prior to the stock dividend, there are just more shares priced at a lower amount per share. Shareholders end up owning more shares at a lower price per share. They also avoid tax liabilities in most cases.
That said, there are two things to keep in mind:
- Cash dividend options could create tax liabilities for shareholders. In the case of stock dividends with a cash option, you could pay tax on a dividend distribution that you haven’t actually realized in cash.
- Changes in dividends can influence a company’s market value. If a company cuts its dividend, income investors might sell the stock and put downward pressure on prices. The opposite may occur if a company raises its dividend.
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The Bottom Line
Dividends have a significant impact on investments. While cash and stock dividends are both dividends in the technical sense, they are very different when it comes to their impact on investors and their tax liability. During the current market uncertainties, it becomes all the more important to understand these impacts to avoid any unexpected problems.
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