Here's our Club Mailbag email investingclubmailbag@cnbc.com — so you send your questions directly to Jim Cramer and his team of analysts. We can't offer personal investing advice. We will only consider more general questions about the investment process or stocks in the portfolio or related industries. This week's question: Hi Jim, could you please do a segment that addresses dividends in detail? I've been investing for many years and listen to many investment podcasts, including "Mad Money," and I always feel the pros/cons aren't described correctly or are misleading. Specifically, I think that most investors (and many advisors) believe that dividends are a free lunch. But my understanding is that they don't create a net win and only create tax churn. — Norm There are two primary ways a company can return cash to shareholders: dividends and buybacks. Both are positive events with relative pros and cons. A buyback occurs when a public company purchases its own shares in the open market and retires them, thereby reducing the number of shares outstanding. Since the share count is the denominator in the earnings-per-share calculation (net income divided by shares outstanding), a reduction in shares increases the EPS for the remaining shareholders. It is also viewed as a vote of confidence by the company and often boosts the stock price. A dividend, on the other hand, occurs when a company takes a portion of its profits and pays it out to shareholders. This is usually done on a per-share basis, which means the more shares you own, the larger the payment. Dividends are typically paid quarterly, though some companies may pay monthly, semiannually, or annually. Key dates for dividends There are three (really four) key dates to be mindful of when it comes to dividends. The declaration date is when the company announces the dividend and the amount to be paid out. The ex-dividend date is the cutoff for receiving dividends. Investors must own the stock prior to this date to receive the payout. A day or two after the ex-dividend date we get the record date (the fourth day noted above). Nothing really to note here for investors, it's simply when the company takes a record of who needs to be paid out. Payout date, when the dividend hits your account. The ex-dividend date is the big one for investors to be mindful of as they need to be in before this date to get the payout. On the day a stock goes ex-dividend, the dollar amount of the dividend is "sucked out" of the share price. So, if a $100 stock pays a $1 quarterly dividend, then on the ex-dividend date, one would expect to see the share price drop to $99 apiece. So, you're still left with $100 of value, you simply now have a $99 stock and $1 in USD (or additional shares should you choose to reinvest). That said, the price adjustment, being that it always happens when the market is open, is often masked by the day-to-day price action resulting from the general buying and selling of shares So, buyback or dividend — which one is preferable? It depends. For those who rely on cash flow from their equity portfolios to live, such as retirees, dividends are usually best. Management teams are reluctant to cut or eliminate dividend payments because it would send a very bad signal to investors about the company's health, making them a reliable source of income to cover regular expenses. However, dividend payments are taxed, even if reinvested. The tax depends on the investor's own financial situation and the type of dividend. Qualified dividends, which carry holding requirements and meet other IRS rules, are taxed at the lower long-term capital gains rate (0% to 20%, depending on income bracket). Ordinary dividends are taxed at the higher ordinary income tax rate. The tax implications are the main reason some investors prefer a buyback, especially those who don't need the cash flow provided by dividends. Share repurchases also come with a tax of only 1%, paid by the company. So, from the shareholder's perspective, there is no perceived tax consequence from repurchase activity. A buyback's impact on EPS is direct, but the return to the shareholder is more indirect, as it still relies on the willingness of multiple investors to place a value on earnings. For example, if you have a $100,000 position in XYZ stock with a 2% yield, you'll receive $2,000 in dividend income per year. So long as the underlying fundamentals are intact, you can rely on the payment being made even if the stock sells off by 20% for reasons unrelated to the company's longer-term financial health, such as a geopolitical event or a broad-based market correction. If, on the other hand, you have a $100,000 position in ABC stock and it doesn't pay a dividend, you may well be able to sell 2% of the stock to raise the $2,000 you need for income. But if the stock sells off, you'll need to sell even more shares to raise the capital you need. Bottom line If you need income from your portfolio to cover expenses, dividends are a good option. However, dividends that are just reinvested are taking a tax hit. (Tax-advantaged accounts are an option, but investors may still need to pay taxes eventually on the dividend-paying stocks, depending on if the account is a Roth or not.) Buybacks are preferable, as they help grow earnings over time without imposing tax liability on the shareholder. For this reason, it's best to hold dividend-paying stocks in tax-advantaged accounts when possible so that you can compound tax-free. (See here for a full list of the stocks INJim Cramer's Charitable Trust.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED. Clarification: This article has been updated to clarify that tax-advantaged accounts are an option, but investors may still need to pay taxes eventually on the dividend-paying stocks, depending on if the account is a Roth or not.
