QUIZ: How do dividends work? Test your knowledge

How do dividends work? Here are the key points every successful investor needs to know

A dividend is a payment a corporation makes to its shareholders, usually as a distribution of profits. When a corporation earns a profit, it can re-invest that surplus in its business and/or distribute a fraction of it as a dividend to its shareholders.

How do dividends work? Test your knowledge below.


When to trust your dividends

“One of the best ways to judge whether a company will keep paying its dividend, or even increase it, is the dividend payout ratio. This simply measures what portion of a company’s earnings are allotted to paying dividends. If a company keeps its payout ratio fairly steady, say at 7% of earnings, and its earnings grow…”
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A. How do dividends work with regards to taxes in Canada?

  1. There is no difference in taxes for dividends in Canada than in the U.S.
  2. The dividend tax credit is given to Canadian investors with stocks held in an RRSP
  3. The dividend tax credit is available on dividends paid to Canadians on Canadian stocks held outside of an RRSP, RRIF or TFSA
  4. The dividend tax credit is only for U.S.-based investors

You are correct if you answered 3.

Canadian taxpayers who hold Canadian dividend-paying stocks get a tax break. Their dividends can be eligible for the dividend tax credit in Canada. This means that dividend income will be taxed at a lower rate than the same amount of interest income.

Investors in the highest tax bracket pay tax of 29% on dividends, compared to about 50% on interest income.

This dividend tax credit is generally available on dividends paid on Canadian stocks held outside of an RRSP, RRIF or TFSA.

B. The best dividend stocks to invest in have which characteristics?

  1. They are stocks that declare dividends in some years but not others
  2. They are stocks that recently paid a dividend for the first time
  3. They are stocks that are popular with the media and analysts
  4. They are stocks that have a history of paying a dividend and they’ve maintained or raised it during economic or stock-market downturns.

You are correct if you answered 4.

The top dividend-paying stocks to invest in have strong positions in healthy industries. They also rely on strong management to make the right moves to keep them competitive in changing marketplaces.

Above all, for a true measure of stability, focus on stocks that pay a dividend they’ve maintained or raised during economic or stock-market downturns. That’s because these firms leave themselves enough room to handle periods of earnings volatility. By continually rewarding investors, and retaining enough cash to finance their businesses, they also provide an attractive mix of safety, income and growth.

C. Dividend Reinvestment Plans (DRIPs) let you:

  1. Save on commissions because they do not require brokers
  2. Avoid the nuisance effect of receiving small cash dividend payments
  3. Sometimes reinvest your dividends in additional shares at a discount to current prices, depending on the company
  4. All of the above

You are correct if you answered 4.

Some companies provide dividend reinvestment plans, or DRIPs, that let shareholders receive additional shares in lieu of cash dividends. DRIPs don’t require the participation of brokers, so shareholders save on commissions.

DRIPs also eliminate the nuisance effect of receiving small cash dividend payments. Additionally, some DRIPs let you reinvest your dividends in additional shares at a discount to current prices. Many DRIPs also allow optional commission-free share purchases on a monthly or quarterly basis.

Overall, we think that DRIPs are OK to participate in. But here are a few things to keep in mind:

  1. Too many investors select their investment ideas solely on the basis of the existence of the DRIP option. We think the availability of a DRIP is a bonus, rather than a reason to invest by itself. Investing in DRIP stocks only limits both investment choice and opportunity.
  2. The advent of low cost discount brokerage and on-line investing has reduced the commission cost of investment trades to low levels. Thus, the commission free investing that DRIP investing allow is less of an advantage today than it was in past.
  3. Taxes are still payable on dividends that are reinvested.

D. How do dividends work in regards to payment dates?

  1. Payment dates don’t follow any sort of rules
  2. There are four key dividend payment dates to know and understand
  3. Dividend dates differ depending on if the shareholder is Canadian or American
  4. None of the above

You are correct if you answered 2.

The declaration date is the date on which a company’s board of directors actually sets the amount of the next dividend. Typically it is a number of weeks in advance of the actual payout date.

The record date is the date on which a person has to actually own shares in the company in order to receive the declared dividend.

The ex-dividend date is typically the last business day before the record date. The ex-dividend date is in place to allow pending stock trades to settle. In short, the security trades without its dividend any day after the ex-dividend date. If you buy a dividend-paying stock one day before the ex-dividend you will still get the dividend; if you buy on the ex-dividend date or after, you won’t get the dividend.

The payable date is the date on which the dividend is actually paid out to the shareholders of record.

E. True or false: High dividend yield stocks are always your best investment options?

You are correct if you answered “False.”

When looking for stocks with high dividend yields, you should avoid the temptation of seeking out stocks with the highest yield—simply because they have above-average yields.

That’s because a high yield may signal danger rather than a bargain if it reflects widespread investor skepticism that a company can keep paying its current dividend. Dividend cuts will always undermine investor confidence, and can quickly push down a company’s stock price.

Use our three-part Successful Investor approach to pick the best dividend stocks

  1. Hold mostly high-quality, dividend-paying stocks.
  2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
  3. Downplay or stay out of stocks in the broker/media limelight.

What have your experiences with DRIPs been?

What is the biggest unexpected issue you’ve run into with dividend stocks?

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