Posted by Fred Lake

How Are Dividends Taxed?

How Are Dividends Taxed?

There are two ways that equity investors make money. Ideally, the price of the stocks you hold increases, giving them a profit when they sell them. Some stocks pay dividends to shareholders at regular intervals, providing them with income to reinvest in stocks or use for other purposes.

Depending on the account type you have for your dividend-paying stocks, you may need to pay taxes on dividend income. Below we will detail how this income is taxed and some of the preferential tax treatments generally available for dividends.


The general rule for dividend taxation 

In general, dividends are handled as income for tax purposes. Unless you hold your dividend stocks in a tax-deferred account, like an IRA or 401(k), you'll need to include your dividends as gross income in the year you receive them.

Many dividends are taxed at lower rates than other types of income. The rules governing dividends giving the right to favorable tax treatment are described below. Dividends that do not meet these requirements are taxed at the same rate as normal income.


Which dividends are eligible for lower tax rates?

For dividend payments to be considered eligible dividends, you have to pass these tests:

  • Dividends must have been paid by a US corporation or a qualifying foreign corporation. This typically requires a foreign company to be covered by a tax treaty with the United States or that its shares be listed on a US stock market, such as the New York Stock Exchange or the Nasdaq Stock Market.

  • Dividends must not fall into specific excluded categories, including tax-free organizations, dividends from mutual banks, or shares held in employee share plans.

  • You must hold the shares for at least 61 days in the 121 days beginning 60 days before the shares will trade without dividends. A longer holding period applies to preferred dividends per share over one year.

If you fail any of these tests, the dividend is not eligible, and normal tax rates apply.


What are the lowest tax rates for eligible dividends in 2021?

Eligible dividends are taxed at lower rates. The exact price depends on your tax filing status and the amount of your taxable income:

Dividend Tax Rate

Single

Married Filing Jointly

Head of Household

Married Filing Separately

0%

$0 to $40,400

$0 to $80,800

$0 to $54,100

$0 to $40,400

15%

$40,401 to $445,850

$80,801 to $501,600

$54,101 to $473,750

$40,401 to $250,800

20%

Above $445,850

Above $501,600

Above $473,750

Above $250,800

Source: IRS.

These numbers are adjusted for inflation each year. So the income limits for 2020 were a bit lower, as you can see here.

In practical terms, these tax rates also correspond (but not exactly) to ordinary income tax brackets. In particular:

  • The 0% tax rate applies to all income between 10% and 12%.

  • The 20% tax rate refers to a small portion of income at the upper limit of the 35% and 37% tax categories.

  • The 15% rate applies to almost all income covered in the 22%, 24%, 32%, and 35% tax brackets.


An additional tax on dividends for high-income taxpayers

Additionally, a net investment income surtax of 3.8% is levied on high-income taxpayers' dividend income. This surtax's limits are $200,000 for singles and head of households, $250,000 for married people who file jointly, and $ 125,000 for married people who file separately.


Be clever with your dividends.

If you want to pay as little tax on dividends as possible, consider the following strategies:

  • Hold dividend stocks in tax-deferred accounts, such as traditional IRAs or similar retirement accounts. You will not pay dividend tax when you file. Instead, you only pay when you withdraw money from your account.

  • Invest in stocks with dividends eligible for lower rates. It is especially important to check foreign companies to make sure they pass the test.

  • Maintain inventory for the required holding period. Short-term trading can turn a qualified dividend into an unqualified dividend by increasing your tax bill.

Dividend stocks are a great way to build wealth and provide necessary income. By knowing these rules, you can make a tax plan that ensures you pay the lowest IRS possible.


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Fred Lake
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