Dividend Tax Types and Rates
One of the great things about stock investing is the payment of dividends, which give investors some extra income simply for owning shares while the company is choosing to distribute part of its earnings to its shareholders. Dividend payments are considered to be income and are therefore subject to taxes at different rates.
Dividend Tax Rates By Type
Some dividends are taxed at the same rate as ordinary income, while others are taxed at a lower rate. The rate of taxation is determined largely by how long you have owned the stock. Generally speaking, most dividends are taxed at the same rate as long-term capital gains, which is lower than the tax on ordinary income.
Qualified dividends are basically dividends paid from stocks or mutual funds that you have owned for a while. Most people pay a tax of 15% on qualified dividend income, though some wealthy people—those who had income of more than $434,550 if single or more than $488,850 if married and filing jointly in the 2019 tax year—pay 20%. A single person earning $39,375 or less or a married couple filing jointly earning $78,750 or less should pay no tax on qualified dividend income on their 2019 federal return.
Net Investment Income Tax
Since 2013, wealthy people have been subject to a 3.8% tax on net investment income—a category that includes dividends, interest, and gains from property sales—as part of the Affordable Care Act. That means the tax rate on qualified dividends for those with a modified adjusted gross income of more than a) $250,000 for married couples filing jointly, b) $125,000 for married couples filing separately, or c) $200,000 for individuals or heads of household is either 18.8% or 23.8%.
For the purposes of calculating the dividend tax, qualified dividends are those paid for common stocks held unhedged (in a way that would prevent or lessen the chance of your losing your investment) at least 61 days during the 121-day period that begins 60 days before the ex-dividend date, which is the first day after a dividend has been declared that the owner of the stock will not be eligible to receive the dividend. (It will instead go to the person who sold the stock to the current owner.) In the case of preferred stocks, you must have held the stock unhedged for 91 days out of the 181-day period beginning 90 days before the ex-dividend date.
When counting the number of days you held the stock, include the day you sold the stock but not the day you bought it.
For dividends paid through mutual funds to be considered qualified, the fund must have held the common shares unhedged for at least 61 days during the 121-day period that begins 60 days before the ex-dividend date. You must also have held shares of the mutual fund for at least 61 of those 121 days. In the case of preferred stocks, the fund must have held the shares unhedged for 91 days out of the 181-day period beginning 90 days before the ex-dividend date.
You must reduce by one day the number of days you can claim to have held the stock for every day you hedged your position in the security. The IRS gives three examples of stock hedging: 1) you had an option to sell, were under a contractual obligation to sell, or had made (and not closed) a short sale of substantially identical stock or securities, 2) you were the writer of an option to buy substantially identical stock or securities, or 3) your risk of loss was diminished by holding one or more other positions in substantially similar or related property.
To be qualified, dividends must also have been paid by either a U.S. corporation or a qualified foreign corporation, which includes one incorporated in a U.S. possession or one that is based in a country that has an income tax treaty with the U.S. The IRS provides a list of countries that have such treaties. The dividends may also be qualified if the stock for which the dividends were paid is traded on a securities exchange in the U.S.
An ordinary dividend is any dividend that doesn't meet those tests for qualified dividends. The tax on these dividends is the same as an investor's personal income tax bracket. If you're in the 22% tax bracket, for instance, you'll pay a 22% dividend tax on these ordinary dividends.
There are some cases when an investor may pay a higher tax rate on dividends regardless. Dividends from shares of real estate investment trusts (REITs), for example, are considered to be long-term capital gains no matter how long you've held the shares and are always taxed as ordinary income.
If you own shares that paid at least $10 of dividends, you should receive a 1099-DIV tax form from your broker outlining how much you earned. This form acts as a guide in helping you determine whether the dividends should be taxed at the rate for qualified or ordinary dividends.
You must report dividends during the year in which they were declared, not in which they were paid.
Many investors choose to use dividend payments to purchase more shares of the same stock. This is called reinvesting, and it's a powerful way to boost the overall value of your investment portfolio.
If you reinvest dividends, you still must pay tax on them. Dividends are always considered income, regardless of whether you use them to buy more stock, place them in a basic savings account, or spend them on a new car.
Avoiding Dividend Taxes
If you are investing using a tax-advantaged retirement account, such as an Individual Retirement Account (IRA) or 401(k), you can avoid paying taxes on dividends—at least right away. Under a traditional IRA and 401(k), investors can avoid paying taxes until they begin withdrawing money when they retire. With a Roth IRA, money is taxed at the time it's invested, but investors do not pay taxes on any gains at retirement time.
Investors can also avoid dividend taxes by investing in stocks that don't pay dividends. Many growth stocks—whose prices are expected to rise substantially based on the companies' increases in revenue and earnings—don't pay dividends and instead reply on higher share prices to reward investors.
TIAA Individual Advisory Services. "2019 Quick Tax Reference Guide." Accessed Jan. 30, 2020.
Internal Revenue Service. "Topic No. 559 Net Investment Income Tax." Accessed Jan. 30, 2020.
Internal Revenue Service. "Publication 17 (2018), Your Federal Income Tax," "8. Dividends and Other Distributions." Accessed Jan. 30, 2020.