Dividends are taxed in different ways - here's how to figure what you owe on your stocks' payouts

dividends2
Dividend income is taxable, but the rate varies, depending on how long you've owned the stock shares that pay the dividends.
  • Dividends from stocks or funds are taxable income, whether you receive them or reinvest them.
  • Qualified dividends are taxed at lower capital gains rates; unqualified dividends as ordinary income.
  • Putting dividend-paying stocks in tax-advantaged accounts can help you avoid or delay the taxes due.
  • Visit Business Insider's Investing Reference library for more stories.

When you invest in a company by purchasing individual stocks, mutual funds, or exchange-traded funds (ETFs), you may be rewarded with dividends. A dividend is a per-share portion of the company's profits that gets distributed regularly to its stockholders - sort of like a quarterly bonus. 

Like most other types of investment income, the IRS deems dividends to be taxable. However, not all dividends are treated - or taxed - equally. 

Here's everything you need to know about paying taxes on dividends.

How are dividends taxed?

A variety of unearned or passive income (as opposed to income from your work or job), dividends are subject to both federal and state taxes. For tax purposes, dividends are classified as either qualified or unqualified, depending on how long you hold the underlying shares in a US corporation or a qualifying foreign corporation.

What's the difference? Qualified dividends meet a special holding period. That means you owned the stock issuing them for at least 60 days during the 121-day period that started 60 days before the ex-dividend date. The ex-dividend date is the day after the cut-off date (aka the "record date") the company uses to determine which shareholders are eligible to receive the dividend.

Yeah, that definition is pretty confusing. So here's a real-life example, sort of a timeline. 

  • Say you purchased 100 shares of IBM stock on March 1, 2020.
  • On April 28, IBM's board of directors announced a dividend of $1.63 per share to stockholders of record.
  • They set the record date as May 8, 2020. So the ex-dividend date was May 9, 2020.
  • Since you purchased the shares more than 60 days prior to the ex-dividend date (May 9, 2020), the $163 in dividends your shares earned you are qualified. On the other hand, if you'd purchased shares on April 1, you would have owned the stock for fewer than 60 days, and the dividends would be unqualified.

How much tax do you pay on dividends?

Why do dividends being qualified or unqualified matter? Because it affects the amount of tax you pay on them. 

Unqualified dividends are taxed at your ordinary income tax rate - the same rate that applies to your wages or self-employment income. So, if you fall into the 32% tax bracket, you'll pay a 32% tax rate on all your unqualified dividends, also known as ordinary dividends.

Qualified dividends get preferential treatment. You pay the same tax rate on qualified dividends as you do on long-term capital gains. Depending on your tax bracket, this rate can be a lot lower than your ordinary income rate.

The exact rate you pay depends on your filing status and total taxable income for the year.

capital gains 06
Capital gains tax rates.

Returning to the IBM example above, let's assume you fall into the 32% tax bracket for ordinary income and the 15% tax bracket for long-term capital gains.

If your IBM dividends are unqualified, you'll pay roughly $52 in taxes on your $163 of dividends. But if those dividends are eligible for qualified tax treatment, you'll pay only $24 in taxes.

How can you avoid paying taxes on dividends?

There are a few legitimate strategies for avoiding or at least minimizing the taxes you pay on dividend income.

  • Stay in a lower tax bracket. Single taxpayers with taxable income of $40,000 or less in 2020 ($40,400 or less for 2021) qualify for the 0% tax rate on qualified dividends. Those income limits are doubled for married couples filing jointly. If you can take advantage of tax deductions that reduce your income below those amounts, you can avoid paying taxes on qualified dividends, though not unqualified dividends.
  • Invest in tax-exempt accounts. Invest in stocks, mutual funds, and EFTs within a Roth IRA or Roth 401(k). Any dividends earned in these accounts are tax-free, as long as you obey the withdrawal rules.
  • Invest in education-oriented accounts. When you invest within a 529 plan or Coverdell education savings account, all dividends earned in the account are tax-free, as long as withdrawals are used for qualified education expenses.
  • Invest in tax-deferred accounts. Traditional IRAs and 401(k)s are tax-deferred, meaning you don't pay taxes on earnings until you withdraw the money in retirement.
  • Don't churn. Try not to sell stocks within the 60-day holding period, so any dividends will be qualified for the low capital gains rates. 
  • Invest in companies that don't pay dividends. Young, rapidly growing companies often reinvest all profits to fuel growth rather than paying dividends to shareholders. You won't earn any quarterly income from their stock, true. But if the firm flourishes and its stock price rises, you can sell your shares at a gain and pay long-term capital gains rates on the profits as long as you owned the stock for more than a year.

Keep in mind: You can't avoid taxes by reinvesting your dividends. Dividends are taxable income whether they're received into your account or invested back into the company.

The financial takeaway

Dividend stocks can be a good way to build wealth and supplement your income, so don't let worries over taxes keep you from investing in dividend-paying stocks. 

Still, by knowing how dividends are taxed, you can do some planning to ensure you pay as little to the IRS as possible. 

Qualified dividends benefit from being taxed at lower capital gains tax rates. And you may be able to lower the tax bite even more if you keep the high-dividend-payers in tax-advantaged accounts.

Related Coverage in Investing:

What are the best college-savings investments? 5 ways to grow your money for the ever-higher costs of higher education

Dividend yield is a key way to evaluate a company and the regular payouts from its stock

Capital gains tax rates: How to calculate them and tips on how to minimize what you owe

How to invest in dividend stocks, a low-risk source of investment income

Interest income from your investments is taxable - here's how to calculate what you owe and ways to lower it

Read the original article on Business Insider


Contributer : Business Insider https://ift.tt/3ttwyFK
Dividends are taxed in different ways - here's how to figure what you owe on your stocks' payouts Dividends are taxed in different ways - here's how to figure what you owe on your stocks' payouts Reviewed by mimisabreena on Friday, February 05, 2021 Rating: 5

No comments:

Sponsor

Powered by Blogger.