How Do Stockholders Earn Income?

by Michael Keenan
Price increases aren't the only way to make money with stocks.

Investing in stocks allows you to put your money to work for you. Assuming the companies you pick do well -- which can be a big risk, depending on your investments -- your money can grow even while you're sleeping. Plus, in most cases you won't pay any taxes on your profits until you cash out your investment.

Price Increase

The obvious way that shareholders profit is when the price of the company goes up. As the market views a company as being more valuable, investors will be willing to pay more money for the shares. This can be because the company is posting large profits, has new products or is expanding into new markets with its existing profits. However, to lock in your profits, you have to sell your stock when the price is high -- otherwise your gains are just on paper and the price could fall before you cash in.

Dividends

Dividends offer a way for stockholders to share in the company's earnings without having to sell their shares. The dividends are paid out proportionally to the company's shareholders based on their percentage of ownership. However, shareholders don't have a right to dividends and some companies don't pay them at all. If you're looking for companies that will pay dividends, most will be mature companies that have limited expansion opportunities rather than start-ups that need to reinvest their profits to build the corporation.

Buyouts

Sometimes, a company that you own stock in will be so attractive to another firm that it will be bought out or merged into the other company. Typically, the acquiring firm has to pay a premium over the current market price to buy out the current shareholders. Depending on how much the acquiring company wants the target, a tender offer could turn a pretty penny for the target's investors. A tender offer is an offer by the potential acquirer to buy all or a certain percentage of shares from the existing shareholders.

Tax Implications

When you realize the income, such as selling shares or receiving dividends, you include the profits as part of your taxable income for the year. For stock sales, if you owned the stock for less than a year, it counts as ordinary income. If you hold it more than one year, the profits are taxed at the lower long-term capital gains rates. Dividends are taxed at ordinary income tax rates unless they are so-called qualified dividends: qualified dividends are those paid by an American company or a company from a country with a tax treaty with the U.S. -- for the dividends to be qualified, though, you must also hold the stock for at least 60 days out of the 60 days before and 60 days after the ex-dividend date, and the payment can't be excluded by law, such as a capital gains distribution. However, if you hold the stocks in a qualified retirement plan, such as an individual retirement account or 401(k) plan, you won't owe any taxes until you take distributions from the account.

About the Author

Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."

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