Many companies couldn’t survive without their shareholders. The funding from shareholders and the stock market provides invaluable liquidity for companies. Shareholders essentially grease the wheels of capitalism.

So, when companies earn profits, many choose to return a portion of those profits to their shareholders.

Of course, they also retain some to reinvest in the company, pay down debt, or build cash reserves, but today we’re going to examine how companies return profits to shareholders in the form of — you guessed it — dividend income.

In this article, you’ll learn what dividend income is, how to determine if a stock’s dividend income is likely to be sustainable, how investors typically use dividend income, and the basics of dividend income tax treatment.

What Is Dividend Income?

The IRS defines dividend income as any distribution of an entity’s property to its shareholders. But truly understanding dividend income requires a deeper look.

Creating dividend income is an important part of any investing strategy. But before you dive in, it’s important to understand why companies choose to pay them and how to interpret dividends from various corporations.

Why Companies Pay Dividends

Dividend payments are a sign of financial health, so a company often offers them to attract investors and to drive its stock’s share price up. Generally, companies pay dividends when they’ve experienced profitability and money is left over after covering operating expenses and reinvesting in the business.

Mature companies, which are already up and running and require less capital reinvestment, are more likely to pay a dividend. Mutual funds, because they aggregate the stocks of these companies, can also pay dividends.

Dividends Are NOT Guaranteed

Dividends provide investors with a way to share in the success of the business they have invested in. But dividends are not guaranteed. The company’s board of directors can decrease — or altogether eliminate — dividend payments at any time.

There is, however, a guaranteed hierarchy that dictates the order in which companies pay out dividends should they go insolvent. And that’s where preferred and common shareholders differ.

Preferred shareholders receive preferentialtreatment in the payout order of a company’s assets and will be paid dividends before common shareholders. Another difference between these two types of stock ownership is that preferred shareholders have no voting rights, while common shareholders do.

Because dividend payments are not guaranteed, it is critically important to understand how sustainable a company’s dividend policy is.

Indicators of Dividend Sustainability

If an organization pays out too much of its earnings to stockholders, it won’t be able to maintaindividend growth or its growth in general. So, analyzing dividend income isn’t as easy as comparing Company A who pays 9 cents per share against company B who pays 4 cents per share.

Instead, adopt a holistic perspective. Understanding the company, its industry, and its current position in that industry is important when assessing sustainability. Is the company likely to remain on its expected trajectory? What does past performance say about the stability of income and dividend payouts?

You shouldconsider a variety of factors, including:

• Market volatility: Competition, supply, demand, and potential disruptions should all be considered. Also, look around at any current events that might impact how the stock will perform in the near future as well as in the long term.
• Payout ratio: A payout ratio is the total amount of dividends paid to shareholders in relation to the total net income of the company. A healthy payout ratio is typically between 30% and 55%. Ratios higher than that are difficult for companies to maintain over the long term.
• Dividend yield: Yield is the ratio of dividend payout per share to stock price per share. Investors typically view dividend yields between 2% and 6% as healthy.

When looking to shore up dividend income, it can be tempting to grab the first dividend stock you see with the highest yield. But this strategy can leave investors exposed to a management team that’s making poor or unethical decisions that don’t create value for shareholders in the long run.

An exceptionally high yield might be an indicator that management is trying to inflate the dividend price to attract more shareholders. Or, it might be the result of a company writing checks it can’t handle. The company may be stretching beyond its capacity and paying out dividends that don’t make sense in relation to its balance sheet and debt levels. And this can mean the stock price is about to take a nosedive.

A holistic perspective is especially important when the dividend yield seems too good to be true. And remember, although it’s important to be wary of high yields that can’t be explained, some dividend stocks with high yieldsare legitimate moneymakers.

How Do Investors Use Dividend Income?

Typically, investors receive dividend income via a check in the mail. Investors can then use that cash just as they would a paycheck. Another way investors receive dividend income is in the form of additional shares of stock.

Investors can use dividend income in a few different ways.

Source of Income

Many people use dividend income in retirement as a source of income. However, since dividend income has no age restrictions like the distributions from a Roth or an IRA account, it can create a stream of income at any point in life.

This additional stream is called passive income — meaning you’re earning cash while you’re busy doing other things — and can create real financial freedom. It can be used for anything your heart desires.

Pay the bills? Sure.

Take a weekend trip at the drop of a hat? Yep!

Although companies pay dividends at various times throughout the year, if strategically designed, you can create a portfolio that pays out each month. When the cash is rolling in each month, dividends can become a steady income stream for you.

Reinvest and Compound

Dividend stocks have a place in every portfolio for a number of reasons. And perhaps the most important reason is compounding.

Some investors won’t need the cash now, so they decide to reinvest. Instead of opting to receive a dividend check, investors can reinvest those dividends back into the stock and essentially buy more shares.

For example, let’s imagine the dividend income this year from stock ABC was $1,000, and the stock price is $100 per share at the time of the dividend payout. If you had opted to reinvest your dividends, instead of being sent a check, the company would take that $1,000 and purchase 10 additional shares on your behalf.

By reinvesting dividend income, wealth snowballs. When you own more shares, the dividends you receive are going to grow. And the larger your future dividend, the more shares the company is buying for you.

Plus, if you’re reinvesting your dividends, you won’t mind seeing a dip in the stock’s share price because this means the company can buy you even more shares.

Let’s take the previous example and assume ABC stock dipped to $50 per share at the time of the dividend payout. Because dividends pay on a per share basis, the drop in price doesn’t affect your dividend payment. You still receive $1,000. But now, instead of buying 10 shares at $100 per share with your $1,000, you will get 20 shares. Because at $50 per share, you can buy more with your $1,000 reinvestment.

Supplement or Offset Capital Gains and Losses

Dividend income has very little to do with capital gains, or the profit you would earn if you sold the company’s stock for more than you initially paid. But you can supplement your capital gains with dividend income.

For example, let’s say you bought a stock at $10 per share and sold it at $15. Your capital gain is $5 per share. But during the time you held the stock, you also had dividend income of $0.10 per share. You’ve simply earned more.

On the other hand, if the stock price goes down, you can protect yourself from capital losses.

For example, let’s say you bought a stock at $10 but sold it at $8. Your capital loss is $2 per share. But the dividend income you earned while you held the stock will offset those losses.

How Does the IRS Treat Dividend Income?

It’s important for investors to understand that the Internal Revenue Service (IRS) sees most dividends as taxable income. Dividend income is classified into two groups: qualified and ordinary.

For every dividend stock you hold, you will be issued an annual Form 1099-DIV, which lays out how much dividend income you earned that year in each of the two groups. Your Form 1099-DIV will also indicate if taxes have been withheld. This way, you’ll know whether or not you need to put aside funds to pay taxes on dividend income.

Qualified Dividends

In order for a dividend to be considered a qualified dividend, the following must be true:

• The payee must be a U.S. corporation or a qualified foreign corporation.
• The investor must hold the underlying stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date.

Complicated, right? Luckily, the dividend stock company’s accountants will handle those requirements and indicate if the dividends are qualified on the Form 1099-DIV.

A qualified dividend is taxed at the capital gains rate, which is lower than the ordinary income tax rate.

The capital gains rate will be 20%, 15%, or 0%, depending on your tax bracket. Most stock dividends in the U.S. qualify for capital gains tax treatment.

Ordinary Dividends

Ordinary dividends, also called nonqualified dividends, do not meet the requirements to be taxed at the lower capital gains rate. These dividends are taxable as regular income at the investor’s ordinary income tax rate on Schedule B.

Dividend Income in Retirement Accounts

Although it’s rare to see good news and taxes mentioned in the same sentence, here is some good news about taxes.

Investors who hold investments in retirement accounts can defer or avoid taxes on dividend income altogether. So, consider keeping dividend stocks in a tax-advantaged retirement account, like an IRA.

Time To Take Action

Dividend income should be contributing to every portfolio. But before you jump in, it’s important to educate yourself so you build a strategic approach.

We’ve given you a good foundation to get you started. You should feel a bit more confident now that you understand what dividend income is, how you can use your dividend payments, and what it might mean for you come tax time.

You’re always looking to generate some extra cash to pay the bills or add a little luxury to your retirement plans. But how can you find the right stocks that will pay consistent dividends?

To learn about three dividend stocks that could lay the groundwork for your retirement, subscribe to the Investors Alley “Dividend Hunter” newsletter.