Here's What Happens When a Company Pays a Special Dividend

Many investors hold dividend-paying stocks in their brokerage accounts because in addition to share price appreciation, they get to make money in the form of dividend income. When a company pays a dividend, what it's doing is sharing some of its profits with stockholders rather than keeping all of the money itself.

Normally, dividends are paid on a quarterly basis. But sometimes, a company will pay a special dividend. And that can be a very good thing, though there are consequences to be aware of.

Why do companies pay special dividends?

A big reason companies pay dividends in the first place is to keep investors happy. When a company finds itself with excess cash on its hands, it may decide to share it with stockholders in the form of a special dividend. Also, in some cases, a company that doesn't pay dividends at all might opt to pay a special dividend.

As an example, Costco is a company that generally pays a steady dividend. But it's also paid a special dividend four times over the past decade or so, the most recent of which was distributed in late 2020.

What do special dividends mean for investors?

A special dividend might seem like a nice windfall -- and to a degree, it is. As an investor, you suddenly have extra money on your hands. And as is the case with regular dividends, there's the option to invest your special dividend and grow that payday into an even larger sum.

But sometimes, paying a special dividend can backfire on the companies that uphold this practice. When a company pays a special dividend, sometimes, investors take it as a sign that the business has no better use for the money and isn't interested in expanding. That could, in turn, lead to a lower stock price.

Another thing you should know is that dividend payments are considered income. This holds true whether you get a special dividend payment or a regular one. And dividend income is subject to taxes, so that's something you'll need to account for. You should also know that you'll be taxed on your dividend income whether you choose to reinvest that money or not.

Now, the good news is that most dividends are considered qualifying dividends. And those are taxed at a more favorable rate than short-term capital gains and ordinary income.

If you're single earning less than $44,625, you actually won't pay taxes on qualified dividends at all. And if your income is between $44,625 and $492,300, you'll only pay 15%. Even those with incomes above $492,300 only pay 20% on qualified dividend income.

All told, you can think of a special dividend as a one-time reward for being an investor. But know what to expect from a tax perspective, and think carefully before rushing to cash that dividend out. Reinvesting that dividend into the company that paid it, or into another stock or ETF, could be your ticket to growing a lot of wealth without having to pump more of your own money into your brokerage account.