The Rewards of Stock Market Investment

In the past four years, we've seen record returns of more than 20 percent annually in the stock market, as measured by the S&P 500 (explained in Understanding Financial Terminology). You know that today you can't get 20 percent interest on your savings account. So, buoyed by the opportunity to make more in the market than with other types of investments, many people have put their money into stocks. They're also putting their kids' money into the market, and now kids are putting their own money in. Essentially, they're becoming stockholders.

Two basic types of shares exist: common stock and preferred stock. Common stock is the most common. Preferred stock offers certain special rights, such as preferential dividends.

If you're in the stock market, how do you put 20 percent into your pocket? It's not like a savings account that pays out interest each year. With stocks, the returns primarily come in the form of appreciation. This is really just a fancy way of saying that the price of the stock increases from the price you or your child paid for it.

The stock market as a whole may rise or fall. Today, we're in an unprecedented bull market where prices have been steadily rising for nearly a decade. But just because the market in general goes up is no guarantee that the price of an individual share will also increase. Market changes are measured by indexes, explained later. These indexes may not account for movement, up or down, in a particular stock.

Stocks offer another benefit: Not only can you enjoy a substantial return on your investment, but you also get a tax break. When stock is sold, you're not taxed on all the proceeds from the sale; you're taxed only on the profits (called gain for tax purposes). This is simply the difference between what you paid for the stock (including any commissions and fees)—your basis in the shares—and what you get for it on the sale. That gain may be taxed at special rates. While salary, interest, and most other income is called ordinary income and is taxed at rates ranging from 15 percent to 39.6 percent, capital gains on stock held for more than one year is subject to a 20 percent tax rate. For people in the lowest tax bracket of 15 percent, which includes most kids, the rate for capital gains is only 10 percent.

Of course, not at all stock picks may be winners, but even losses get special tax treatment. They can be used not only to offset gains, but up to $3,000 of losses are deductible against ordinary income.

It's important to keep these tax considerations in mind. After all, it's not what you make but what you keep after tax that's important. So, if your 16-year-old child works a part-time job and pays 15 percent tax on her income, she's not doing as well as if she invests money in the market and pays only 10 percent on her gains.

Cash Dividends

Appreciation isn't the only thing that stocks provide. Some, not all, may pay a set amount for each share owned. This payment is called a dividend and reflects the profits earned by the company and shared with its shareholders.

Even if the price of stock never goes up, a dividend-paying company is another way to earn income. You can figure what the dividend yield is by dividing the amount of the annual dividend by the price of the stock. For example, if the annual dividend is $4.00 per share and the current price of the stock is $50, the dividend yield is 8 percent ($4 ∏ $50). An 8 percent yield from a dividend certainly beats a 5 percent yield on the bank CD.

If paid at all, dividends are usually paid quarterly, although they can be paid semi-annually, annually, or just at one time. Dividends are quoted according to their annual amount, or four times the quarterly payment. So, a $4.00 per share dividend means that $1 per share will be paid each quarter.

Dividends are paid to shareholders “of record.” Record shareholders are those who own the shares on that date. It's important to know who the record shareholders are because the stock can change hands by the time the dividend is actually paid out. Investors who buy stock that has gone ex-dividend (without dividend) don't get the shares. Ex-dividend is three trading days after the day the dividend is declared.

When you were in school and someone called you a drip, you were insulted. Today, however, DRIPs (dividend reinvestment plans) are great. Under a DRIP, cash dividends paid by companies are automatically used to buy additional shares (or fractions of shares) in the same company. More than 1,000 companies today, including AT&T, Ford Motor Co., Heinz, and Intel, have DRIPs. For some of them, one share of stock is necessary to get started. Brokerage firms also allow for automatic dividend reinvestment for shares held in “street name” (a shorthand way of saving the name of the brokerage firm).

To check on whether a company offers a DRIP, ask your broker or check out Standard & Poor's Directory of Dividend Reinvestment Plans at your local library.

Dividends are reported annually to shareholders (and to the IRS) on Form 1099-DIV. Taxes are paid on dividends even if they're reinvested in additional shares.

Stock Splits

Some companies may believe the price of their stock is too high to attract new investors, and they may decide to split the shares. For example, in a two-for-one stock split, an investor receives two shares in place of each one share he owns. If he starts with 100 shares, he'll have 200 after the split. Other examples of stock splits include a three-for-one split (three shares in place of each one) and a three-for-two split (three shares for each two shares owned). My daughter bought 10 shares of Gap with gifts she received for her bat mitzvah. Today, eight years later, she owns 45 shares without having put in another penny.

A split doesn't immediately affect the total value of what an investor owns. The value before the split is spread among the new shares. So, if 100 shares were worth $50 each, or $5,000, the new 200 shares are worth $25 each, for the same $5,000 total value.

As a practical matter, stock splits may result in eventual appreciation in an investor's holdings. The price of stock after a stock split tends to go up, and it takes only half as much of a price rise to boost the value following a two-for-one split.

Excerpted from The Complete Idiot's Guide to Money-Smart Kids © 1999 by Barbara Weltman. All rights reserved including the right of reproduction in whole or in part in any form. Used by arrangement with Alpha Books, a member of Penguin Group (USA) Inc.

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