You may be rewarded with dividends when you invest in a company by buying individual stocks, mutual funds, or exchange-traded funds (ETFs). A dividend is a per-share portion of a company's earnings regularly distributed to its shareholders as a quarterly bonus.
Like most other types of investment income, dividends are considered taxable by the IRS. However, not all dividends are treated or taxed the same.
Here's what you need to know about paying taxes on dividends.
How are dividends taxed?
A variety of passive or unearned income (as opposed to labor or employment income) and dividends are subject to federal and state taxes. For tax purposes, dividends are classified as eligible or non-eligible depending on how long you owned the underlying stock of the qualifying US or foreign corporation.
What is the difference? Eligible dividends have a special holding period. This means that you held the shares that were issued for at least 60 days during the 121-day period that began 60 days before the ex-dividend date. The ex-dividend date is usually the day after the cut-off date (also known as the "record date") that the company uses to determine which shareholders are eligible to receive the dividend.
Yes, this definition is quite confusing. So here is a concrete example, a sort of chronology.
Assume you purchased 100 XYZ shares on March 1, 2021.
On April 21, XYZ's Board of Directors announced a dividend of $1.63 per share to registered shareholders.
The board then goes ahead to set the record date as May 8, 2021. Therefore, the ex-dividend date was May 9, 2021.
Because you purchased the shares more than 60 days before the ex-dividend date (May 9, 2021), the $163 in dividends earned on your shares are eligible. If you had bought the stock on April 1, you would have held it for less than 60 days, and the dividends would not have been eligible.
How do you know if your dividends are eligible or not?
Do not worry; there is no need to track ex-dividend data and determine for yourself which dividends are not qualified. By January 31 of each year, you will receive Form 1099-DIV from any company or broker that paid you at least $10 in dividends or other distributions during the previous year. Your total dividends are shown on Schedule 1a of Form 1099-DIV, and your eligible dividends are shown on Schedule 1b.
How much tax do I pay on dividends?
Why is it important whether dividends are qualified or non-qualified? Because it concerns the amount of tax you pay on them.
Non-qualified dividends are taxed at the normal income tax rate, the same rate that applies to wages or self-employment income. So if you fall in the 32% tax bracket, you will pay a 32% tax rate on all your non-eligible dividends, also known as ordinary dividends.
Eligible dividends receive preferential treatment. You pay the same tax rate on eligible dividends as on long-term capital gains. Depending on the tax bracket, this rate could be much lower than the normal income rate.
The exact tax payable depends on your filing status and total annual taxable income.
How to avoid paying taxes on dividends?
There are legitimate strategies to avoid or minimize the taxes you pay on your dividend income.
Do not churn: Try not to sell stocks during the 60-day holding period so that dividends qualify for low capital gains rates.
Invest in companies that do not pay dividends: Young, fast-growing companies, often reinvest all profits to fuel growth rather than paying dividends to shareholders. You won't get any quarterly income from your stocks. But if the company does well and your stock price goes up, you can sell your stock at a profit and pay long-term capital gains tax on the profit as long as you hold the stock for longer than a year.
Invest in education-focused accounts: When you invest in a Coverdell 529 Plan or Education Savings Account, all dividends earned in the account are tax-free as long as the withdrawals are used for eligible educational expenses.
Invest in tax-deferred accounts: Both traditional IRAs and 401(k)s are tax-deferred, meaning you don't pay tax on your earnings until you withdraw your money.
Invest in tax-exempt accounts: Invest in mutual funds, stocks, and EFTs in a Roth 401(k) or Roth IRA. Any dividends earned in any of these accounts are tax-free if you follow the withdrawal rules.
Stay in a lower tax bracket: Individual depositors with taxable income of $40,000 or less for 2020 ($40,400 or less for the 2021 tax year) are eligible for the 0% tax rate on eligible dividends. These income limits double for couples filing jointly. If you can take advantage of tax deductions that reduce your income below these amounts, you can avoid paying tax on eligible but not on non-eligible dividends.
Please note: you cannot avoid tax by reinvesting your dividends. Dividends are taxable income received in your account or reinvested in the business.
The Bottom Line
Dividend-paying stocks can be a great way to build wealth and supplement your income, so don't let tax worries keep you from investing in stocks that pay dividends.
However, knowing how dividends are taxed, you can plan to ensure you pay the IRS as little as possible.
Eligible dividends are taxed at lower capital gains tax rates. And you can further reduce your tax burden by keeping big dividend payers in tax-efficient accounts.
Summary
Dividends from stocks or funds are taxable income, whether received or reinvested.
Eligible dividends are taxed at lower capital gains rates; dividends are not considered ordinary income.
Placing dividend-paying stocks in tax-free accounts can help you avoid or delay paying taxes.
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Dennis Jao