Dividends Explained: The Most Passive Form of Income There Is

Dividends Explained: The Most Passive Form of Income There Is

Here's why Coca-Cola wants to cut you a paycheck even though you're not on their payroll

Aug 11, 2021

Dividends Explained: The Most Passive Form of Income There Is
Stock Trading

Stock Trading

Passive Income

Passive Income

Business

Business

Partying in your crib, sipping Cristal, and sleeping in...only to wake up to a notification that Coca-Cola just paid you $100 again to thank you for being a stockholder. No work, all play—and pay. Can the dream really exist? 

Some of the richest people in the world are making millions if not billions in passive income from dividends. Shark Tank's Mr. Wonderful, Kevin O'Leary, can often be found waxing poetic about his love for these stock market cash cows.

While it might take a while to build up billions, working your way up to a steady monthly dividend check is easier than you'd think. If you invested just $150 per biweekly paycheck in popular dividend stock Johnson & Johnson, for example, you'd be earning $100 per month in passive income off that one stock in under eight years. 

So, what are dividends? How do they work, and can you really live off of them if you're not rolling in millions to start? Let’s find out.

Hold up: What are dividends?

You might already know the basics of playing the stock market: you buy them when the price is low, wait for them to go up in value, and sell them at a higher price. Those profits are called "capital gains," and it's what most people think of when they think about making money off stocks.

Dividends are another way to make money off the stock market. Some companies choose to use a portion of their profits to make regular payments to shareholders as a sort of reward for holding onto their stock. It's kind of like the way American Express might reward you with some cash back for spending money on one of their credit cards. These payments are normally made on a monthly, quarterly or yearly basis, although some dividends are given as one-off payments too.

Do all companies pay dividends?

Not all companies offer dividends to investors. Dividends are mainly given by large, profitable companies that don’t need to use as much of their profits to reinvest back into their business. You can choose to reinvest your dividends automatically or cash them out as passive income.

There are also opportunities to earn dividends outside of the stock market. Real estate investment platforms tend to offer monthly, quarterly, or annual payouts since real estate is an income-generating asset. For example, Crowdstreet pays certain investors a portion of the profits earned on their properties, and you earn that in addition to any increase in value of the property.

crowdstreet

CrowdStreet

4.5

Real Estate

Fig is another example of an alternative to the stock market that pays dividends. This platform lets you invest in video games designed by independent creators, and you earn regular passive income from that game's sales.

fig

Fig

Startups

Are dividends really money for nothing?

You don’t need to be a hustler to earn money with dividends. Instead of spending 80 hours a week pranking innocent bystanders in hopes of becoming the next Jake and Logan Paul, you can set up automatic deposits into your favorite dividend stocks and let your money do all the hard work for you. 

As one of the most passive forms of income, you’re essentially receiving money just for investing in stocks—and it's extra money on top of what you’re already holding as investments. The checks will be small at first, but if you contribute money to your investments regularly and reinvest your dividends, you'll see them grow pretty quickly.

An extra slice of the pie: How dividends work

When you invest in a company paying out dividends, you’ll receive a payment for each share of a stock you own. To determine the dividends you’ll be paid, you need to look at the dividend yield. Look up a stock, and if it pays dividends, you can see how much under "Div yield." For example, you'll see below that Coca-Cola's current dividend yield is 2.97%—anything between 2% and 6% is generally considered good.

<h3><span style="background-color:transparent;color:#000000;">An extra slice of the pie: How dividends work</span></h3>

The dividend yield is the yearly dividend value divided by the stock value on a specific date. Let’s say your favorite fast food company pays $1 in annual dividends per share and the stock trading value is $20 for each share. The dividend yield would be 5%. 

Want to know how much you’d make with a 5% dividend yield? If you own 100 shares at a trading price of $20 each, the $1 each in annual dividends would net you an extra $100 per year for doing nothing. Now, if you reinvest those dividends and continue investing a portion of your paycheck in this stock, that number can turn into $1,000, and then $10,000, and even $100,000.

Shoot for the moon or settle down?

If you'd started investing $1,000 a month in Coca-Cola back in 2000, and you reinvested the dividends, you'd be earning nearly $2,000 a month in passive income from that one stock now. 

With that much money, you could cover the mortgage payment on a nice little house in most cities and still have nearly $1 million saved up for retirement. Or, you could keep investing for a few more years, sell all your shares, and buy two tickets to space onboard Richard Branson's Virgin Galactic rocket ship. Which route do you take?

Shoot for the moon or settle down?

Getting the goods: The best ways to earn dividends

The two main ways to earn dividends are through traditional stocks or through real estate investment trusts (REITs), which are kind of like stocks but for real estate. Here are a couple apps that make it easy.

Get help picking the best dividend stocks for you

Investing apps make it easy to start buying stocks with very little money. A favorite among dividend-hunters, M1 is fee-free and lets you invest as little as $100. The app will help you create a balanced portfolio and set up recurring buys, and it automatically reinvests your dividends back into your stocks so you can grow your wealth quicker. 

m1

M1

4.3

Robo Advisor

Earn above-average dividend yields with real estate

While 3% is a great dividend yield for stocks, REITs (which are funds invested in real estate rather than public companies) often pay upwards of 5%. Fundrise is an app that lets you invest in a REIT with just $10, and they pay monthly dividends that you can automatically reinvest or receive as a cash payment.

fundrise

Fundrise

5.0

Real Estate

I'm ready to be a billionaire already...when can I retire early off dividends?

Will dividends really make you rich? Before you start dreaming of buying your own Richard Branson island and checking in on your billions with a mai tai in hand, there are a few things to consider. 

Dividends are a long game

Dividends are a great form of passive income. But if you really want to maximize your earning potential, you either need to be willing to regularly invest large amounts of cash or hold your investment portfolio for at least 20 years. 

This is particularly true because dividend-paying stocks don't tend to be high-growth stocks, although they do offer consistent returns. Companies that aim to grow quickly are more likely to reinvest their profits than pay them out to shareholders.

Stocks are risky business

In the short term, investing in stocks can be risky. Share value naturally fluctuates over time, meaning that your initial investment can fall if the stock price reduces. Plus, a high dividend yield isn’t always a good indicator of a healthy business as the company may be giving out profits to investors rather than growing their business. However, holding stocks over a long period and diversifying your portfolio by adding several different kinds of stocks are a few ways to minimize your risk.

Dividend income is taxable

Dividends are taxed at varying rates depending on your income and the amount of dividends you receive. However, some people won’t pay any dividend tax, particularly if you’re on a low taxable income.  

While you may not be quitting your day job soon, dividend investing is a great way to start earning extra money that can be used as another stream of income or to grow your wealth faster. The earlier you start the better, even if you have only $10 to spare.

True or False:

The best stocks pay dividends.

True or False:

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