What Are Dividends? How Do They Work? Source of Passive Income

Looking for a way to get an extra source of income? Want to gain some cash coming to your bank account despite the ups and downs of the market? Want to create a passive income source? Let's discuss all in this article!

What are dividends?

Whenever you buy some share of a company, you become the owner of that portion of the company. Suppose, for example, there is a company called 'A' and they have 1000 shares. The price of each share is 50 INR. You buy 2 shares by paying 100 INR. This, technically and legally, makes you the 0.2% owner of company 'A'.

When companies make a profit, they use it in two ways -

  • They can use this profit to make new changes in the company to make them better like by increasing their product portfolio or by spending it on advertisements or marketing or whatever.

  • Distribute it among the shareholders.

The second point where they distribute the profits among the shareholders in what is called dividends. Small-cap companies generally spend all their profits to increase their product catalog and marketing while large-cap companies spend some amount for the growth of companies and distribute the remaining among shareholders as dividends.

Do remember that every company does not declare dividends. It completely depends on the discretion of the company if they wish to share their profits or not. A company that has consistently declared dividends in the past can stop it and a company that has never declared dividends can also start it.

Can dividends be a good source of passive income?

Before jumping on to details, let me explain what passive income means. Passive income is termed as the income generated from those fields where you aren't actively working or where you haven't put in your considerable time or efforts.

If you wish to earn passive income from dividends, you got to select those companies which have a good history of dividend payouts because we as humans do tend to make those things which we keep on doing as habits. So, the probability of a company paying dividends is higher if they have a good history of paying dividends.

The next thing that you got to check is the dividend yield. Mathematically, the dividend yield is the amount the company provides as a dividend per share in a year divided by the current stock price of the company. For example, if the current stock price of the company is 100 and they have declared 10 as the dividend in the entire year, this makes their dividend yield at 10%. This is just an example, do not take it seriously. The dividend yield of the most generous companies generally tends to float around 5-6%.

Finally, the most important thing to keep in mind so as to receive dividends. Just owning the shares of the company does not make you eligible for dividends. There is a term called ex-dividend date. Any company that has to pay dividends must know to who they need to pay this amount. So, to get a record of who they need to distribute this dividend with, they declare a date, and any person who owns one or more shares of the company before this date is eligible to receive payment in the form of dividends. If the ex-dividend date is 5th Aug, then everyone who owns stocks of the company on 4th Aug is eligible to receive this dividend payout.

How to pick dividend stocks?

To pick stocks that payout dividends regularly, you need to spend a bit of time and do a bit of research. The easiest way to do this research is to visit screener.in (not sponsored) and check the list of companies paying dividends on regular basis and in a good amount as well.

Some of my picks for dividends include ITC, Coal India, IOCL, SAIL, NALCO, Bajaj Auto, and Infosys. This is not a piece of investment advice. Pick your stocks at your own discretion.

How are dividends taxed?

A dividend is a source of income and hence it is subject to income tax. Whenever a dividend is declared, 10% of it is deducted as TDS. The rest of the amount you receive is considered your income so when you pay income tax at the end of the financial year, you have to pay taxes on it as per your income tax slab.

I personally use "Groww" for investing in stocks and mutual funds and so far I do not have any complaints against them. This is not sponsored. However, if you are planning to open an account using Groww, you can use my referral link, through it both of us can get ₹100 deposited in our account when you activate your account on Groww. It is a win-win situation. Click here to open an account on Groww.

With this, we have made it to the end of yet another article. I hope you have gained something new. Consider giving it a like and sharing it among your friends and family. It will motivate me to keep writing new articles for you. To get notified whenever I publish new articles, sign up to the NerdyTree by hitting the "log in" button at the top of the page.

Let me know if you have any doubts regarding dividend income. Drop them in the comments.