Understanding the Relationship Between Retained Earnings and Dividend Payouts

Priscilla Wolfe
Feb 1, 2024
3 min read

Updated: Jan 16

Retained earnings, often referred to as accumulated earnings or, cumulative profits or losses of a company since its inception. Retained earnings are the portion of a company's net income that is retained or reinvested into the business rather than distributed to shareholders as dividends.

Managing Retained Earnings

Monitor Profitability: Regularly review the company's income statement to track profitability trends. Understanding the factors driving net income will help you make informed decisions about reinvesting profits or distributing dividends.
Budgeting and Forecasting: Use budgeting and forecasting to create financial projections and set goals for retained earnings. This will help you plan for future expenses, investments, and dividend payments.
Dividend Policy: Establish a clear dividend policy that outlines when and how dividends will be distributed to shareholders. Ensuring compliance with your dividend policy. Note: Dividend Payouts should be recorded to a separate Dividend Paid Equity Account, not retained earnings. Retained Earnings should be reserved to account for profits and losses from previous years, without adjustments, making reconciliation of the previous years accumulated profits and losses from the Profit and Loss Statement, and retained earnings balance accurate. QuickBooks Online automatically and electronically swaps funds from your net income or loss into the account and doesn't record any visible transactions for it.
Tax Planning: Consider the tax implications of retaining earnings versus distributing dividends. Retained earnings are taxed (at 20%) differently from dividends, so consult with a tax advisor to develop a tax-efficient strategy for any accumulated taxable earnings. Retained earnings can be kept in a separate account and are tax-exempt until they are distributed as salary, dividends, or bonuses. Salary and bonuses can be deducted from corporate income tax, but are taxed at the individual level. How are distributions and dividends taxed differently? Dividends are paid with after-tax money – thus they are double taxed; distributions are paid with before-tax money – thus they avoid being double taxed. The IRS treats distributions as a payout of company equity.
Reinvesting Profits: Evaluate opportunities to reinvest retained earnings into the business to fuel growth and expansion.

The Relationship Between Retained Earnings and Dividends

The decision to retain earnings or distribute them as dividends depends on various factors, including the company's financial goals, growth opportunities, and shareholder preferences. When a company retains earnings, it retains control over its capital and can use it to finance growth initiatives, repay debt, or build cash reserves for future needs. On the other hand, when a company pays dividends, it rewards shareholders for their investment and may attract new investors seeking income.

When a corporation declares dividends to be paid from the retained earnings the transaction would be recorded as:

To record the declaration of dividends:

Debit: Dividend Equity Paid

Credit: Dividends Payable (or credit cash if paid immediately) OR

Credit: Dividends Declared (contra retained earnings) *Use common stock tax form detail type in QuickBooks Online.

An example of how a contra transaction would be presented:

Retained Earnings (before dividends): $100,000

Dividends Declared (contra account): -$20,000

Retained Earnings (after dividends): $80,000

To record the payment of dividends:

Debit: Dividends Payable OR

Debit: Dividends Declared

Credit: Cash

An additional Retained Earnings Contra account can be established to record the Reinvested Profits using the same workflow.

When considering dividend payments to shareholders some examples of considerations would include:

Growth Stage: In the early stages of a company's life cycle, retained earnings may be low or even negative as the company reinvests most of its profits into growth initiatives. As the company matures and becomes profitable, retained earnings typically increase.
Profitability: Companies that consistently generate profits and have a history of retaining a portion of those profits for reinvestment tend to have higher retained earnings balances.
Dividend Policy: Companies that pay out a large portion of their earnings as dividends will have lower retained earnings balances compared to companies that retain more earnings for reinvestment.
Industry Norms: Different industries have different capital requirements and growth trajectories, which can influence typical levels of retained earnings.
Financial Health: Retained earnings also reflect the financial health and stability of a company. A healthy balance sheet typically includes a reasonable level of retained earnings to support future growth and weather economic downturns.

It's essential for business owners and investors to assess a company's retained earnings in the context of its unique circumstances and industry benchmarks. Comparing retained earnings to factors like total assets, total equity, and net income can provide additional insights into a company's financial performance and growth prospects.