What is a dividend?

A dividend is a sum of money that is paid by a limited company, organisation, investment trust or fund to its shareholders out of the profits it has generated. Dividends can be paid on an annual basis, or every three-six months, and can be paid in cash, shares or property.

Dividends are, essentially, a reward given to shareholders for investing their money in a company or fund. Dividend-paying investments are especially popular in times of uncertainty or market volatility as they provide a more reliable source of income. They must be paid from recorded post-tax profit and not cash reserves, as it is illegal to pay them from the latter.

While dividends are beneficial for shareholders, they also help the company or fund paying them. Keeping up a reputation for paying good, regular dividends shows a company to be reputable and trustworthy, and encourages new investors to buy shares. This is why many limited companies will aim to pay consistent dividends, using money from profit generated in previous years if recent profits aren’t sufficient to warrant such payments.

Who are dividends paid by?

Dividends are mainly paid by:

•         Public limited companies
•         Mutual funds
•         Exchange-traded funds

A company’s board of directors must meet to determine whether dividends are to be paid and if so, how much and at what intervals. There is nothing dictating companies must pay out dividends, so it is up to their boards to decide whether it is a beneficial move. 

Larger corporations are more likely to issue more regular and higher value dividends as they generally generate higher profits and are better at forecasting them.

Smaller or newer companies are usually less inclined to pay dividends as there is more risk because many are loss-making or have fluctuating levels of profit.

How are dividends paid?

Before paying out a dividend, a company must go through a few steps. A clear timetable for issuing dividends must be set out; this usually takes a form like this:

1. Declaration date. This is the day the board of directors announce that they are issuing a dividend. If the plan is supported by shareholders, the company will pay out the agreed amount to shareholders. The share price will usually rise as a result.
2. Ex-dividend date. Shares that are bought in the company after this date will not have a guaranteed dividend. In other words, only owners of shares bought before this date will receive the dividend. The share price usually falls after this date.
3. Payment date. The date on which shareholders receive the arranged dividend payment.

Dividends are usually paid annually, bi-annually or quarterly depending on the company’s preference. For instance, a dividend of £1 per share paid quarterly would see shareholders paid 25 pence every quarter. Company dividends can only be paid from post-tax profit. Investment funds pay dividends in a slightly different way – essentially they are paid from the fund’s net asset value in the shape of interest payments on its assets.

Types of dividend

•       Cash dividend. This is the most common way for companies to pay dividends – it is simply a cash payment in the form of a cheque or bank transfer.
•       Property dividend. This is a dividend paid in tangible property assets rather than cash.
•       Stock dividend. Companies may choose to pay out dividends in the form of shares. For instance (assuming the company paid stock dividends equivalent to the market price of the shares), if a shareholder owned 1,000 shares worth £50 each, and received a stock dividend worth 50p per share, they would be paid 10 new shares in the company.

Dividend Reinvestment Plans (DRIPs)

On most of the occasions shareholders receive a stock dividend, it is because they have entered into a dividend reinvestment plan (DRIP). A DRIP is an agreement between company and shareholder that dividends will always be paid out in the form of shares, allowing the shareholder to constantly reinvest their returns back into the company.

DRIPs hold great advantages for both companies and shareholders. Companies benefit from them as they continue to receive further investment from existing shareholders – more than they are likely to from a cash dividend. DRIPs allow shareholders to keep investing easily, while often being given shares at discounted rates compared to their market value. 

Tax on dividends

Dividends are subject to taxation, although companies and funds do not have to pay tax on the dividends they issue.

For shareholders, tax must be paid on dividends received which exceed their individual allowance. In the UK, the government tax-free allowance on dividend payments is £2,000 per year, although this dropped from £5,000 annually in 2017.

Tax paid on dividends exceeding the tax-free allowance corresponds to your income as a whole, including all dividends you receive. For instance, if your total income makes you a basic rate taxpayer, tax on dividends exceeding £2,000 will be 7.5%. For higher rate payers, this jumps to 32.5% and for additional rate payers, it is 38.1%.