Due to changes in the tax rules, dividend income and capital gains have become more attractive sources of passive income for investors. Coupled with other intelligent portfolio allocation strategies—like taking advantage of employer 401(k) matching and fully funding a Roth IRA—these changes to dividend tax laws can drop your tax bill by a meaningful amount.
The Basics of Dividend Tax Rules
As of the 2019 tax year, individuals who make less than $39,375 in taxable income, and married couples who make less than $78,750, do not pay federal taxes on qualified dividends and long-term capital gains. State taxes may still apply, but even in states with higher tax rates, paying no federal taxes remains a huge benefit.
Increasing your dividend income by a dollar is now more advantageous to you on an after-tax basis than earning an extra dollar of income from your labor. This is especially true if you are self-employed and face higher effective taxes due to the double payment on the regressive payroll tax for Social Security and Medicare (where a larger percentage of a lower-earners income is taxed than a high-earners) that requires you to cover both the employer and employee portion.
Individuals earning a taxable income of $39,376–$434,550, and married couples earning $78,751–$488,850 pay 15% in federal taxes on their dividend income. Individuals earning $434,551 or more and married couples earning $488,851 or more pay 20%. There is also an additional 3.8% net investment income tax (NIIT) for individuals earning more than $200,000 and married couples earning more than $250,000.
How to Keep More of Your Passive Income
Individuals earning less than $39,375 in taxable income and married couples earning less than $78,750 could prioritize building up a long-term, diversified portfolio of dividend growth and high dividend yield stocks.
Wealthier families with adult children can lower their estate taxes, take advantage of the annual gift tax exclusion, and keep more investment income in the family through a relatively simple technique. Parents can give their adult children highly appreciated shares of dividend-paying stocks, passing along the cost basis and unrealized gain, but not triggering the deferred taxes.
The children aren't as likely to be earning as high an income as the parents—especially if they're just starting their careers—so unless they qualify for one of the child tax rules, the dividend income generated from the very same shares will be tax-free at the federal level. This can be huge if combined with liquidity discounts in a family limited partnership. The major downside from a tax perspective is the loss of the eventual stepped-up basis loophole (where non-wealthy families build up wealth over time and want to pass assets on, resetting the current fair market value and reducing capital gains taxes).
A Taxation Example
Imagine you live in New York and are in the top federal tax bracket. Any dividends you collect are going to be taxed at 23.8% at the federal level (20% for the base tax and 3.8% for the NIIT), plus be subject to an 8.8% state tax and 3.9% local tax. By the end, you're going to lose 36.5% of your dividend income to taxes.
Let's say you have a child who's married and launching a startup business in Dallas. While he isn't yet making any money at the startup, his spouse makes $50,000 a year as a teacher, which puts them beneath the $78,750 tax-free dividend exemption level. You can gift your child and their spouse dividend stocks each year, knowing the dividends won't be taxed at the federal level.
Since Texas has no state income tax, that is a considerable amount of money that will go in their pockets and not to the IRS. This tactic also helps move money out of your estate, so that future appreciation on those shares won't be subject to the estate tax limits when you die.
How to Pay Nothing in Capital Gains Taxes
Sticking with the same scenario discussed above, an equally effective strategy involves having your child and their spouse sell the appreciated stocks you gifted since the capital gains in their tax bracket are also tax-free. They can wait for the wash sale rule period (capital losses cannot be claimed if an investment is repurchased within 30 days of sale) to pass and then repurchase the investment.
This lets you offload the capital gains tax to your children, have them trigger the tax, and keep the money that would have otherwise gone to the government. If the person is fairly young, say 25–35 years old, they can save thousands of dollars—which they can then keep on their personal balance sheet to compound for many years.
Utilize this strategy for multiple children and grandchildren, and it is possible to save significant amounts on your (and their) tax bill. By transferring an asset from one pocket to another, and accelerating inheritances, you can let your heirs enjoy more of the fruits of your labor. It's a viable alternative to something like a charitable remainder trust, which can also provide major tax advantages.