Are dividends better for investors than stock buybacks? It all depends

Here's our Club Mailbag email address—sendingclubmailbag@cnbc.com—to send your questions directly to Jim Cramer and his team of analysts. We cannot offer personal investment advice. We will only address more general questions about the investment process or stocks in the portfolio or related sectors. This week's question: Hi Jim, can you please do a section that goes into detail about dividends? I've been investing for many years and listen to many investing podcasts, including "Mad Money", and I always feel like the pros/cons are not properly described or are misleading. Specifically, I think most investors (and many advisors) believe dividends are a free lunch. However, as far as I understand, these do not create a net profit, they only create a tax loss. — The 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 publicly traded company purchases its own shares in the open market and retires them, thereby reducing the number of shares outstanding. Since the number of shares is the denominator in the earnings per share calculation (net income divided by the number of shares outstanding), a decrease in shares increases EPS for the remaining shareholders. It is also seen as a vote of confidence by the company and often increases its stock price. Dividends, on the other hand, occur when a company takes a portion of its profits and pays them to shareholders. This is usually done on a per share basis; so the more shares you own, the larger the payout. Dividends are usually paid quarterly, but some companies may pay monthly, semi-annually or annually. Important dates for dividends There are three (actually four) important dates to pay attention to when it comes to dividends. The declaration date is the date on which the company announces the dividend distribution and the amount to be paid. The ex-dividend date is the cut-off date for receiving dividends. Investors must own shares before this date to receive the payment. We get the record date one or two days after the ex-dividend date (the fourth day mentioned above). There's really nothing to consider here for investors, it's just that the company keeps track of who needs to be paid. Payment date is the date the dividend reaches your account. The ex-dividend date is the most important date that investors should pay attention to because they need to be ready before this date to receive the payment. The day a stock goes ex-dividend, the dollar amount of the dividend is "absorbed" from the stock price. So, if a $100 stock pays a quarterly dividend of $1, the share price can be expected to fall to $99 per piece on the ex-dividend date. So, with $100 still left, you now have $99 worth of stock and $1 USD (or additional shares if you choose to reinvest). However, since the price adjustment always occurs when the market is open, it is often masked by daily price movements resulting from general buying and selling of shares. Well, buyback or dividend; Which one is preferred? It depends. Dividends are often best for those who rely on cash flow from their equity portfolios to live, such as retirees. Management teams are reluctant to cut or eliminate dividend payments because it would send a very bad signal to investors about the health of the company, making them an unreliable source of income to cover regular expenses. However, dividend payments are taxable even if they are reinvested. The tax depends on the investor's own financial situation and the type of dividend. Qualified dividends that meet holding requirements and 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. Tax implications are the main reason why some investors prefer buybacks, especially those who do not need the cash flow provided by dividends. Share buybacks are also subject to only a 1% tax paid by the company. So, from the shareholders' perspective, there are no perceived tax consequences due to the buyback activity. The impact of a buyback on EPS is direct, but the return to shareholders is more indirect because it still depends on the willingness of multiple investors to value earnings. For example, if you have a $100,000 position in XYZ stock with a 2% return, you would receive $2,000 in dividend income per year. As long as fundamental fundamentals are solid, you can count on the payment to be made even if the stock sells off 20% for reasons unrelated to the company's long-term financial health, such as a geopolitical event or a broad-based market correction. On the other hand, if you have a $100,000 position in ABC stock and it isn't paying dividends, you can sell 2% of the stock to raise the $2,000 you need for income. However, if the stock sells, you will need to sell more shares to raise the capital you need. Bottom Line If you need income from your portfolio to cover your expenses, dividends are a good option. However, reinvested dividends take a tax hit. (Tax-advantaged accounts are an option, but investors still must pay taxes on dividend-paying stocks.) Buybacks are preferred because they help grow earnings over time without imposing a tax liability on shareholders. Therefore, it's best to keep dividend-paying stocks in tax-advantaged accounts whenever possible so you can compound tax-free. (See here for a complete list of INJim Cramer's Charitable Trust stocks.) When you subscribe to the CNBC Investment Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trading alert before buying or selling a stock in his charitable foundation's portfolio. If Jim talked about a stock on CNBC TV, he waits 72 hours after issuing the trading alert before executing the trade. THE ABOVE INVESTMENT CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY, TOGETHER WITH THE DISCLAIMERS. NO CIVIL OBLIGATIONS OR DUTIES EXIST OR SHALL BE RESULTING FROM YOUR RECEIVING ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTMENT CLUB. NO SPECIFIC RESULT OR PROFIT GUARANTEE IS MADE.