- Dividend Download
- Posts
- 🏠Dividend taxation
Dividend Download
Top dividend stocks & news
Understanding U.S. Dividend Taxation
The taxation of dividends in the U.S. depends on how the Internal Revenue Code (IRC) categorizes them—either as qualified or ordinary dividends.
Qualified dividends benefit from the same lower tax rates applied to long-term capital gains, while ordinary dividends are taxed at standard federal income tax rates, ranging from 10% to 37% for the 2023 and 2024 tax years. This difference in taxation can significantly affect the investor’s after-tax income.
The chart below shows 2024 tax rates:
What Qualifies a Dividend?
To determine if a dividend is qualified, three conditions generally apply:
The dividend must be paid by a U.S. corporation or qualifying foreign company.
It must be an actual dividend, meaning it cannot come from non-dividend-paying entities like insurance refunds or credit union distributions.
The stock must be held for a specific period—typically more than 60 days during a 121-day window surrounding the ex-dividend date.
Failing to meet these conditions may result in the dividend being treated as ordinary, incurring a higher tax rate.
Taxation of Ordinary Dividends
Ordinary dividends, paid by most common and preferred stocks, are taxed like regular income.
Investors must report these dividends on their tax returns and pay the same tax rate as they would on wages or other earnings.
Ordinary dividends are typically taxed at higher rates than qualified dividends, as they do not benefit from capital gains tax treatment.
How to Report Dividend Income
Investors receive Form 1099-DIV from their brokers detailing the dividends paid throughout the year.
This form distinguishes between qualified and nonqualified dividends, making it easier for investors to file their taxes.
If you receive more than $1,500 in dividends, you will also need to fill out Schedule B.
Even dividends that are automatically reinvested, such as in a Dividend Reinvestment Plan (DRIP), must be reported as taxable income.
Managing Your Dividend Tax Liability
To minimize the tax burden on dividends, investors can:
Watch holding periods: Ensure stocks are held for the required time to qualify for the lower dividend tax rates.
Set aside cash for taxes: Since taxes aren't automatically withheld from dividend payments, investors may need to make estimated tax payments.
Use tax-advantaged accounts: Holding dividend-paying stocks in a retirement account, such as a traditional IRA or Roth IRA, can shelter dividends from immediate taxation or defer tax obligations (more on this below).
Nonqualified Dividends and Taxation
Nonqualified dividends, taxed at the same rate as ordinary income, apply to distributions from real estate investment trusts (REITs), certain foreign corporations, and other pass-through entities.
These dividends do not receive the favorable tax treatment of qualified dividends, making them more costly from a tax perspective.
Strategies to Minimize or Avoid Dividend Taxes
There are several effective ways to reduce or completely avoid taxes on dividends, depending on whether they are qualified or ordinary. Below are key strategies investors can consider:
Leveraging Roth Retirement Accounts
A Roth IRA offers one of the best ways to avoid taxes on dividends. Since contributions are made with after-tax income, any earnings, including dividends, are tax-free upon withdrawal. As long as the investor is at least 59 ½ years old and the account has been open for at least five years, dividends can be withdrawn tax-free. This strategy makes Roth IRAs highly attractive for tax-efficient investing.
Qualifying for Zero Capital Gains Tax
Another way to avoid dividend taxes is by qualifying for the zero capital gains tax rate. Capital gains taxes are progressive, meaning higher-income earners pay more. Reducing your taxable income through contributions to retirement plans or health savings accounts (HSAs) can help you fall within this bracket and avoid paying taxes on dividends.
Using Education Savings Plans
Investors who are saving for education expenses can use 529 plans, which allow for tax-free growth and withdrawals when used for qualified educational costs like tuition and books. This tax-advantaged plan enables you to invest in dividend-paying stocks, allowing your investments to grow tax-free. However, to avoid taxes on withdrawals, the funds must be used exclusively for qualifying education-related expenses.
Utilizing Traditional Retirement Accounts
Traditional IRAs and 401(k)s provide tax-deferred growth, allowing you to delay taxes on dividends. These accounts are funded with pre-tax dollars, lowering your current taxable income. However, withdrawals during retirement are taxed at your ordinary income tax rate. Although this doesn't completely eliminate your tax liability, it does allow you to defer it until retirement, potentially lowering your tax rate when the dividends are eventually withdrawn.
Beware: High Earners and the Net Investment Income Tax
High-income investors with modified adjusted gross incomes above $200,000 (single filers) or $250,000 (married couples) may also be subject to the Net Investment Income Tax (NIIT).
This 3.8% tax applies to dividend income and capital gains, adding an additional layer of taxation for affluent investors.
Are Dividends Taxed Twice?
Yes, dividends are subject to double taxation. Corporations first pay taxes on their earnings, and then shareholders pay taxes on dividends received from these earnings. This process can lead to a higher effective tax rate on investment income.
Conclusion: Maximizing Dividend Tax Efficiency
The tax treatment of dividends can significantly impact investment returns. By understanding the distinction between qualified and nonqualified dividends, utilizing tax-efficient strategies, and knowing how to report dividend income, investors can better manage their tax liabilities.
Check this interesting video for more:
Resources
👩🏽‍⚖️ Legal Stuff
Nothing in this newsletter is financial advice. Always do your own research and think for yourself.