Dividends are one of my favorite things to collect. Even John D. Rockefeller understood the power of dividends. He has been quoted as saying, “Do you know the only thing that gives me pleasure? It's to see my dividends coming in.” Buy a stock that pays a dividend, and a company pays you passive income every quarter in the U.S. and semi-annually in most other countries.
However, in most cases, everyone must pay taxes on dividends. In the U.S. and most other countries, for that matter, dividends are considered income, and hence they are taxed.
In the U.S., though, dividends can have favorable tax treatment for many small investors, making them tax efficient in regular brokerage accounts. It is also possible for dividend-paying stocks to be held in tax-advantaged accounts delaying or reducing federal income tax on dividends.
1. Why do Investors Love Dividends So Much?
Why do dividends matter to investors? There are several reasons investors like dividends. One of the most important is that dividends are a return of cash to an investor. A company can return some money to stock owners by buying back shares or paying a dividend. However, when a company pays a dividend, the investor decides what to do with that money. You can reinvest the money and buy additional shares of the same company. Alternatively, you can purchase shares of a different company. A third option is that you can keep the cash and do something else with it. John Bogle said it best:
“Successful investing is about owning businesses and reaping the huge rewards provided by the dividends and earnings growth of our nation's–and, for that matter, the world's– corporations.”
Dividends are also a metric used to determine financial health. Companies that pay a dividend have the earnings and cash flow to do so. However, when companies experience financial difficulties, such as during times of economic duress, they may freeze their dividends or, even worse, cut or suspend their dividends. For instance, during the sub-prime mortgage crisis and the Great Recession from 2008–2009, many banks slashed their dividend rates to zero.
Similarly, during the COVID-19 pandemic, many companies in the energy, retail, travel, and hospitality industries cut or suspended their dividends. These companies faced low oil prices and plunging demand, severely impacting their revenue, earnings, and cash flow.
Dividends can also contribute to total return, lower portfolio volatility, and provide downside protection when the market is declining. Historically, dividend-paying stocks have outperformed those that do not pay dividends. Importantly, dividends may also be tax-efficient since tax on a certain type of dividend is treated favorably at the long-term capital gains tax rate.
2. What is the Tax Rate on Dividends?
Dividend tax rates differ depending on whether the dividend is qualified or nonqualified, also known as ordinary. The difference in the tax rate can be dramatic depending on your income. Families in the highest income tax bracket pay a 37% tax rate on regular income and only a 20% tax rate on dividends. For families closer to the median U.S. family income of about $67,521 in 2020, the tax rate on regular income is 12%, but it is 0% on dividends. Think about it; you pay no income on your dividends. No wonder dividend-paying stocks have become so popular in the past decade.
The concept of qualified dividends was implemented in the U.S. when the 2003 tax cuts were signed into law. Before this law went into effect, dividends were taxed at the regular income tax rate. Qualified dividends have an advantageous tax rate. But not all dividends are qualified. According to Investopedia, a dividend must meet the following criteria to be qualified.
- Paid by a U.S. company or a company in a U.S. possession
- Paid by a foreign company residing in a country that is eligible for benefits under a U.S. tax treaty
- Paid by a foreign company that can be easily traded on a major U.S. stock market
The stock must also meet the requirement for a minimum holding period. The stock must have been owned for greater than 60 days during the 121 days beginning 60 days before the ex-dividend date. On the ex-dividend date, an investor who buys a stock is not eligible for the dividend payment. The stock price is trading ex-dividend on this date.
There are only three qualified dividend tax rates depending on your income tax bracket, keeping it very simple. The tax rates on qualified dividends are 0%, 15%, and 20%, whether you are a single filer or are married and filing jointly, depending on your income. For example, in 2020, if you earned less than $40,000 per year as a single filer or $80,000 per year as married and filing jointly, you paid no tax on qualified dividends.
On the other hand, suppose you earned between $40,001 and $441,450 per year as a single filer or $80,001 and $496,600 per year as a married couple filing jointly; you paid 15% taxes on qualified dividends. Lastly, if you earned $441,451 or more per year as a single filer or $496,601 or more per year as a married couple filing jointly, the qualified dividend tax rate was 20%.
All other dividends are nonqualified dividends or ordinary dividends. Dividends in this category include stocks that do not meet the above criteria, REITs, and MLPs. Nonqualified dividends are taxed at the higher regular federal income tax rate.
There are multiple tax rates for nonqualified dividends. The tax rates on ordinary 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 Is It?
You must pay taxes on dividends, but how do you tell if your dividends are qualified or nonqualified? Making this determination is not a difficult task, and there is nothing to worry about. You don't need to keep track of the ex-dividend dates. Instead, you should receive a 1099-DIV from your brokerage firm listing all your dividends.
The 1099-DIV will state whether the dividend is qualified or not. For your tax returns, all you need to do is to make the correct entry for qualified and nonqualified dividends to report your income properly.
If you own an MLP, you will receive a Schedule K-1 that will show taxable dividends.
Example of Qualified vs. Nonqualified
Let’s look at a real-world example of the difference between qualified and nonqualified dividends.
Coca-Cola (KO) is well known as a dividend growth stock. The company's board of directors announced a dividend of $0.42 per share on July 14th, 2021. The ex-dividend date was September 14th, and the record date was September 15th. According to the rules for qualified dividends, you must own the stock 60 days before September 14th. If you had bought the stock on July 1st, then the dividends received are qualified. However, if you bought the stock on August 1st, the dividends are nonqualified since you bought the stock within the 60-day window before the ex-dividend date.
3. Can You Avoid Taxes on Dividends?
In general, the answer is no, but there are exceptions. Dividends are a type of income, so they are taxable. Reinvesting dividends in the same stock or mutual fund or ETF, for that matter, does not avoid taxes. You must still pay taxes on the dividends.
That said, you can avoid investing in companies that pay dividends. Unfortunately, plenty of companies do not pay dividends and instead return cash to investors through share buybacks.
Alternatively, you can avoid earning too much money and stay below the cutoff income for taxes on dividends. All you need to do is earn less than $40,000 as a single filer or $80,000 as a married couple filing jointly, and there is no tax on your dividends.
4. What About Tax-Advantaged Accounts?
More people own a retirement account than a taxable brokerage account. Owning a retirement account is an advantage and a legitimate way to defer or avoid taxes on dividends. It is also a good way to leverage the power of compounding by reinvesting the dividends tax-free.
If you invest in a Roth IRA or Roth 401(k), the dividends earned from stocks, ETFs, or mutual funds are tax-free. However, you must follow the rules for withdrawals though otherwise, there is a tax penalty.
If you invest in a traditional IRA or 401(k), the dividends earned from stocks, ETFs, or mutual funds are tax-deferred. In this case, you don't pay taxes on the dividends until they are withdrawn.
A third scenario is that you can invest in a 529 plan. In this case, dividends earned from stocks, ETFs, or mutual funds are tax-free. The caveat, though, is that the withdrawals must be used for qualified education expenses.
Final Thoughts in Taxes on Dividends
Taxes on dividends can quickly be a complicated subject. The reason being is that there are variations of regular cash dividends. Some companies issue stock dividends whose treatment can be complicated. Sometimes, REITs and MLPs pay nonqualified dividends and return cash through distributions that are viewed as a return of capital and thus have more complicated tax rules. However, the basics are simple. Qualified dividends are tax-efficient and require an investor to hold onto a stock for a longer-term.
This post originally appeared on Wealth of Geeks.
Prakash is the founder of the Dividend Power site. He is a self-taught investor and blogger on dividend growth stocks and financial independence. Some of his writings can be found on Seeking Alpha, TalkMarkets, ValueWalk, The Money Show, Forbes, Yahoo Finance, Entrepreneur, FXMag, and leading financial blogs. He also works as a part-time freelance equity analyst with a leading newsletter on dividend stocks. He was recently in the top 1.2% (98 out of over 8,252) of financial bloggers as tracked by TipRanks (an independent analyst tracking site) for his articles on Seeking Alpha.