Investor's Guide to the Dividend Tax
How the Dividend Tax Works and the Dividend Tax Rates
One of the great things about investing in stocks is that they often pay dividends, giving an investor some extra income simply for owning shares. A dividend comes when a company decides to distribute portions of its earnings to shareholders. But it's important to remember that dividend payments are considered income, and therefore are subject to taxes.
The dividend tax is one of the most common investment taxes paid by investors, whether they own 100 shares of Johnson & Johnson or 1,000,000 shares of McDonald's.
The rules on how the dividend tax works and specific dividend tax rates, however, are not very well understood. This guide was put together to help you understand the basics. [See also: Dividends 101 - Your Complete Introduction to Dividends and The Ultimate Guide to Dividends and Dividend Investing.]
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 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: In a basic sense, qualified dividends are dividends paid from stocks that you have owned for a while. They are taxed at the same rate as long-term capital gains. For most people this means you'll pay 15% on dividend income, though some wealthy people (anyone making more than $425,900 if single, $479,000 if married could pay as much as 20%. A single person earning less than $38,600 or married couple earning les than $77,200 will pay no tax on dividend income.
For the purposes of calculating the dividend tax, ordinary dividends are for stocks held more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. In short, the best advice to avoid higher dividend taxes is to hold on to your stocks for a least a few months. (This rule is in place to discourage investors from getting income from a company that it did not invest in for very long.)
- Non-Qualified, or Ordinary, Dividends: A non-qualified dividend is any dividend that doesn't meet the test of qualified dividends (see above). These are also often referred to as "ordinary" dividends. The dividend 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 non-qualified dividends.
There are some cases where an investor may pay a higher tax rate on dividends regardless. Dividends from shares of real estate investment trusts (REITs), for example, are always taxed as ordinary income.
If you own shares that paid dividends, you will likely receive a 1099-DIV tax form from your broker outlining how much you earned. This form will tell you whether the dividends should be taxed at the rate for qualified or non-qualified dividends.
What if You Reinvest Your Dividends?
Many investors will choose to take dividend payments and use them to purchase more shares of the same stick. 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 considered income, regardless of whether you use them to buy more stock, place them in a basic savings account, or use them to buy tickets to the movies.
How to Avoid 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 tax on dividends (at least right away.) Under a traditional IRA and 401(k), investors can avoid paying tax until they begin withdrawing money when they retire.
With a Roth IRA, money is taxed now, but investors do not pay tax on any gains at retirement time.
Investors can also avoid dividend taxes by investing in stocks that don't pay dividends. While the lack of a dividend payment may indicate a company in trouble, it's more likely a sign that the company prefers to use its earnings to reinvest and grow the company. Often (but not always) this results in faster share growth for company stock.
Edited and Updated by Tim Lemke.