What is Dividend Income: Types, Benefits, Taxation and Rules
Any reward given by a company to its shareholders, whether in cash payment or stocks, is called a dividend. Companies that regularly earn profits may distribute them as dividends to their shareholders on a monthly, quarterly or annual basis. However, it is not mandatory for any company to issue dividends.
The dividend is either a portion of the company’s profits or taken from its reserves as a part of an agreement between the company and shareholders. The company’s board of directors decides the dividend declaration after approval from shareholders. Regular dividend income increases investors’ confidence in the company, which increases its share price.
How Dividends of a Company Work?
When a company earns profits, it can choose to reinvest in its business or reward its shareholders after paying its creditors. A company offers a bonus in the form of liquid cash, stocks or other benefits to encourage more investments.
Today, many companies and AMCs (Asset Management Companies) have adopted the practice of paying dividends. Dividend payouts are a gesture of goodwill and are not compulsory for any business. They can skip paying dividends when they face cash shortages or need cash for reinvestments.
When a company wants to distribute its profits, its management team, along with the board of directors, approve the planned dividend. Then, they announce the record date, value per share and date of issue of the dividend. Anyone who bought shares within this record date is eligible for dividend income in proportion to his/her shareholding.
The company usually mails the cheques of the dividends to shareholders within a week or so of announcing them. One can buy or sell stocks with dividends within two days before the record date, and then they turn into ex-dividend, i.e. they do not generate dividend income.
Types of Dividends Issued
The following are the various types of dividends that companies can pay to their shareholders.
- Cash Dividends: This is the most preferred mode of distributing dividends to shareholders. Businesses usually make the payment electronically directly to the shareholder’s bank account. Sometimes, the method of payment can be through cheque or cash.
- Stock Dividends: Companies that do not have sufficient cash reserves typically prefer this option. A company issues this to investors on a pro-rata basis, based on the number of shares that the investors own. Many investors prefer this option as they can choose to convert them into cash anytime they want.
- Asset Dividends: Companies are not limited to issuing dividend income as cash or shares. They can also distribute their assets, including physical assets, real estate or investment securities etc., as dividends.
- Special Dividends: This is paid outside a company’s standard policy and issuing date. This usually happens when the business has excess cash in hand and wants to distribute extra profits.
- Scrip Dividends: Businesses without enough funds can choose to issue scrip dividends. These are promissory notes that guarantee payment to shareholders at a later date.
- Liquidating Dividends: A company that is about to shut its business makes a final payment to shareholders as dividends after settling all their dues.
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Mature companies earning regular returns over several years pay out dividends to their shareholders. Their primary reason is to increase the value of their stocks and attract new investors. In addition, they do this to reassure shareholders about the company’s financial status.
Investors see dividend payouts as a sign of a business’s underlying value. Regular dividend payments increase investors’ confidence as it sends a positive message about its future prospects. New investors are also interested in the stocks of a company offering regular dividend income.
Benefits of Choosing Stocks Offering Dividends
1. Source of Regular Income
Stocks with a high dividend yield offer a steady source of income from the company’s profits. Stockholders can use them for immediate profits or reinvest to buy additional shares of the company.
2. Reflects a Company’s Future Earnings
Many established companies disburse their annual profits among investors every year to establish their goodwill. Investors see the dividend yield of a company to assess its underlying value.
3. Less Risky Option
Companies issuing dividends usually have a strong market presence and the ability to generate profits consistently. Dividends are also a strong sign of a company’s reliability and an indicator of profitability in the future. Hence, these stocks typically carry lower risks than growth stocks.
4. Less Prone to Market Volatility
Dividend stocks are usually less prone to market volatilities as the companies are strong and steady with sufficient cash flow. Thus, many investors simply buy and hold these stocks due to their stable nature.
5. Scope for Capital Appreciation
Companies that pay high dividend income and grow their earnings tend to produce attractive returns. Investors can use the money from dividends to buy more shares and reap the benefits of higher yield in the future.
Taxation Rules for Dividend Income
From FY2020-21, any dividend from shares of Indian companies is taxable in the country. In the case of resident Indians, dividend income is added to their taxable income and taxable as per their income tax slab rates. Previously, companies issuing dividends had to pay a dividend distribution tax (DDT) on their payouts.
The dividend income for NRIs (Non-Resident Indians) has a 20% tax applicable plus surcharge and a 4% health and education cess. They may also benefit from any DTAA (double taxation avoidance agreement) between India and the country of their residence. This allows them to avoid double taxation.
Income from dividends is also subject to TDS (Tax Deducted at Source) of 7.5% for dividends greater than Rs. 5,000 in a financial year. The Indian government cut the rate from 10% in March 2021 due to the COVID-19 pandemic.
Final Word
Some companies offer dividend income as an incentive for investors to buy their stocks. Investing in such stocks is a great way of earning a steady income while benefitting from capital appreciation.
Dividend-yielding stocks generally carry less risk as they have to regularly generate profits to offer dividends. However, investors should do their due research before investing and not judge a company’s value on dividend payouts alone.
FAQs
Ans: The dividend yield is the percentage of dividends issued per share in a year against its current share price. This value indicates the amount of money one might receive from a company based on its current price. Investors use this figure to compare a stock’s relative value against its market peers.
Ans: A high dividend yield is not a good enough indicator for purchasing stocks. For example, a company offering a high dividend yield when its share price is low may be experiencing financial troubles.
On the other hand, a company with a low dividend yield may be focusing on growth and investment, which is better for it in the long run. Therefore, companies cannot have good or bad dividend yields.
Ans: While a company not paying dividends may be experiencing financial troubles, there are several good reasons like the following to not pay dividends:
• Well-established companies often reinvest their earnings to pay off debt and fund new initiatives.
• From a fiscal point of view, it makes more sense for a business to reinvest in its operations.
• Expanding companies will not want to spend their funds during pivotal growth stages.
Ans: Yes, a failing company may want to attract new investors with a high dividend yield. By offering such attractive deals, it can increase its stock price to get out of financial trouble. Therefore, investors might want to check a company’s earnings growth and other fundamentals before investing.
Ans: No, paying dividends is not an obligation for any organisation. It is entirely up to the company to decide if it wants to continue paying dividends to shareholders or avoid such payments. Lack of profits, necessary spending, plans for expansion or an increase in tax rates are some reasons for a company to cut its dividend payouts.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
