Dividends are one of my favorite things that I collect. Even John D. Rockefeller understood the power of dividends. He was quoted as saying, “Do you know the only thing that pleases me? This is to see my dividends. ” Buy stocks that pay dividends and the company will pay you passive income quarterly in the US and semi-annually in most other countries.
In most cases, however, everyone must pay dividend tax. In the United States and most other countries, dividends are considered income and are therefore taxed.
However, in the United States, dividends can be taxed favorably for many small investors, making them more tax efficient when using conventional brokerage accounts. Dividend-paying stocks can also be held in tax-exempt accounts, which defer or reduce federal income tax on dividends.
1. Why do investors love dividends so much?
Why are dividends important to investors? Investors love dividends for several reasons. One of the most important is that dividends are the return of funds to the investor. The company can return some of the money to the owners of the shares by buying back the shares or paying dividends. However, when the company pays dividends, the investor decides what to do with that money. You can reinvest money and buy additional shares of the same company. Alternatively, you can purchase shares of another company. The third option is that you can keep the money for yourself and do something else with it. John Bogle put it best:
“Successful investing is about owning a business and receiving huge rewards through dividends and growth in corporate income in our country and, for that matter, around the world.”
Dividends are also an indicator of financial health. Companies paying dividends have profit and cash flow for this. However, when companies are in financial distress, such as during economic pressures, they can freeze their dividends or, worse, cut or suspend their dividends. For example, during the subprime mortgage crisis and the Great Recession of 2008-2009, many banks lowered their dividend rates to zero.
Likewise, during the COVID-19 pandemic, many companies in the energy, retail, tourism and hospitality industries have cut or suspended their dividend payments. These companies faced low oil prices and falling demand, which seriously affected their revenues, profits and cash flow.
Dividends can also help boost overall returns, reduce portfolio volatility, and provide protection against losses in the event of a market downturn. Historically, stocks that pay dividends have outnumbered stocks that don’t pay dividends. It is important to note that dividends can also be tax efficient, as tax on a certain type of dividend is treated favorably at the capital gains tax rate over the long term.
2. What is the tax rate for dividends?
Dividend tax rates vary depending on whether the dividend is qualified or unqualified, also known as ordinary. The difference in tax rate can be significant depending on your income. Families with the highest income tax pay 37% tax on regular income and only 20% on dividends. For families close to the median household income in the United States of about $ 67,521 in 2020, the tax rate is 12% on regular income and 0% on dividends. I think about it; you do not pay income on your dividends. It’s no surprise that stocks with dividend payouts have become so popular over the past decade.
Qualified dividends?
The concept of qualified dividends was implemented in the United States when the Tax Cuts Act was signed into law in 2003. Prior to the entry into force of this law, dividends were taxed at the regular income tax rate. Qualified dividends have a favorable tax rate. But not all dividends are qualified. According to Investopedia, dividends must meet the following criteria to qualify.
- Paid by a US or US owned company.
- Paid by a foreign company domiciled in a country that is eligible for US tax treaty benefits.
- Paid by a foreign company that can be easily traded on the major US stock market.
Shares must also meet the minimum holding requirement. Shares must be held for more than 60 days within 121 days starting 60 days before the ex-dividend date. On the ex-dividend date, the investor buying the shares is not entitled to dividend payments. On this day, the share price is traded excluding dividends.
There are only three qualified dividend tax rates depending on your tax category, which is very simple. The tax rates on qualified dividends are 0%, 15% and 20%, regardless of whether you are an individual filler or married and filing jointly, depending on your income. For example, in 2020, if you earn less than $ 40,000 per year as a single filing party or $ 80,000 per year in marriage and co-filing, you were not paying qualified dividend tax.
On the other hand, suppose you earn $ 40,001 to $ 441,450 per year as a single applicant or $ 80,001 to $ 496,600 per year as a joint applicant couple; you paid 15% tax on qualified dividends. Finally, if you earn $ 441,451 or more per year as an individual applicant or $ 496,601 or more per year as a joint filing married couple, the qualifying dividend tax rate is 20%.
Unqualified dividends
All other dividends are unqualified dividends or ordinary dividends. Dividends in this category include shares that do not meet the above criteria, REITs and MLPs. Unqualified dividends are taxed at the higher standard federal income tax rate.
There are several tax rates for unqualified dividends. The tax rates for regular dividends are 10%, 12%, 22%, 24%, 32%, 35% and 37% depending on your income. These rates are the same as the regular federal income tax rate.
Which one?
You must pay taxes on dividends, but how do you tell if your dividends are qualified or unqualified? This definition is not difficult and there is nothing to worry about. You don’t need to track ex-dividend dates. Instead, you should receive a 1099-DIV from your brokerage firm showing all of your dividends.
1099-DIV will indicate whether the dividend is qualified. For your tax returns, all you have to do is make the correct entry for qualified and unqualified dividends in order to report your income correctly.
If you have an MLP, you will receive Table K-1, which will list the taxable dividends.
An example of skilled and unqualified
Let’s take a look at a real-world example of the difference between qualified and unqualified dividends.
Coca-Cola (KO) is well known as a dividend-increasing stock. The company’s board of directors announced a dividend of $ 0.42 per share on July 14, 2021. The ex-dividend date is September 14th.th, and the recording date was September 15th… According to the rules for qualified dividends, you must own the stock 60 days before September 14th.th… If you bought stock on July 1stst, then the received dividends are qualified. However, if you bought shares on August 1stst, the dividend is unqualified because you bought the stock within the 60-day window prior to the ex-dividend date.
3. Is it possible to avoid paying taxes on dividends?
In general, no, but there are exceptions. Dividends are a type of income and are therefore taxable. Reinvesting dividends in the same stocks, mutual funds, or ETFs, for that matter, doesn’t avoid taxes. You still have to pay taxes on dividends.
However, you can avoid investing in companies that pay dividends. Unfortunately, many companies do not pay dividends and instead return the money to investors through share buybacks.
In addition, you may not be making too much money and stay below the dividend tax income threshold. All you have to do is earn less than $ 40,000 as an individual applicant or $ 80,000 if married together and your dividend is not taxed.
4. What about tax-exempt accounts?
More people have retirement accounts than tax-deductible brokerage accounts. Owning a retirement account is an advantage and a legal way to defer or avoid dividend taxes. It is also a good way to take advantage of compounding opportunities by reinvesting dividends without paying taxes.
If you invest in a Roth IRA or Roth 401 (k), dividends received from stocks, ETFs or mutual funds are not tax deductible. However, you must comply with the withdrawal rules, otherwise a tax penalty will be charged.
If you invest in a traditional IRA or 401 (k), dividends received from stocks, ETFs, or mutual funds are tax deferred. In this case, you do not pay taxes on dividends until they are withdrawn.
The third scenario is that you can invest in a 529 plan. In this case, dividends received from stocks, ETFs or mutual funds are not taxed. However, the caveat is that withdrawals must be used to cover the cost of qualified education.
Final thoughts on dividend taxes
Dividend taxes can quickly become a daunting task. The reason is that there are variations of regular cash dividends. Some companies issue dividends on stocks, which can be difficult to process. Sometimes REITs and MLPs pay unqualified dividends and return cash through distributions, which are considered capital returns and therefore have more complex tax rules. However, the basics are simple. Qualified dividends are tax efficient and require the investor to hold the stock for a longer period.
This post was originally published on Wealth of Geeks.
Disclaimer: Dividend Power is not a licensed or registered investment advisor or broker / dealer. He does not give you individual investment advice. Please consult a licensed investment professional before investing.