Kevin O’Leary, that famous investor from the Sharktank, once said he would “never own a stock that doesn’t pay dividends.”
Kevin O’Leary, like many other intelligent investors, understands the power of dividend-paying stocks.
But did you know that dividends can be taxed at the same rate as your income?
Yup. That means your dividends can be taxed as much as 37% according to 2021 tax brackets.
And the lowest you’d be paying in 2021 is 10% if your income falls in the lowest tax bracket.
And let’s be honest, people wouldn’t even want to pay 10% taxes on their dividends if they don’t have to.
To be a smart investor, you don’t just want to watch your money grow. You also want to save on unnecessary payments when you can (specifically on taxes).
So how are dividends taxed you ask?
After you read this article, you’ll understand how dividends are taxed, how you can pay less on dividend taxes, and even how to completely avoid dividend taxes (in a completely legal way).
How are dividends taxed?
Dividends are broken up into two different categories: qualified dividends and ordinary dividends.
Generally, dividends are treated as regular income by the IRS. This means that your dividends will be taxed depending on how much you make per year. Even if you’re reinvesting those dividends.
But, lucky for you some dividends get a special tax treatment depending on certain qualifications that we’ll get into in a bit.
Let’s break down the difference between the two types of dividends.
Qualified dividends are taxed like capital gains. If you don’t know what capital gains are, that’s okay.
This basically means your dividends qualify for tax benefits and will be taxed at a lower rate than normal income.
The brackets for capital gains fall in either 0%, 15%, or 20%. This is a lot lower than the normal income tax brackets that you would be subject to with ordinary dividends.
The table below shows the 3 tax rates you can fall under depending on your annual income.
2021 Qualified Dividends Tax Rates
You can see that the lowest tax bracket for qualified dividends is 0%. And if you’re familiar with income tax brackets, you’ll know that the lowest tax bracket is 10% as of 2021.
So if you compare taxes on qualified dividends versus ordinary dividends, you’ll see that there’s a massive difference between the two.
So if your dividend-paying company qualifies for the favorable tax benefits, then all you’ll need to do is meet the holding period.
In other words, you’ll just need to hold the stocks for a certain amount of time to reach these tax benefits.
Now you’re probably wondering how the heck dividends even become qualified in the first place. So let’s go into detail together.
How do dividends become qualified?
To classify as a qualified dividend, there are three factors that the dividend-paying company has to meet.
A.) The company has to be an American company - or a qualifying foreign company.
B.) Can’t be on the unqualified list with the IRS
C.) And it must meet one of the following holding periods depending on the type of the company.
At least 90 days for a preferred stock
At least 60 days for a common stock
At least 60 days for a dividend-paying mutual-fund
If you’re investing in a company and you’re not sure if they pass the A and B criteria above, then you may want to consider speaking to a tax professional. For example, sometimes companies aren’t straightforward about whether or not they’re on the unqualified list with the IRS.
Like we said earlier, ordinary dividends are taxed like regular income.
So, to find how much you’re going to pay on your ordinary dividends, you can look up income tax for the specific year that applies to you.
You probably don’t want to be in this category unless you absolutely love paying more in taxes.
Let’s use an example so you can understand how ordinary dividends and qualified dividends would play out.
Let’s say you purchase 2000 shares of common stock that pays monthly dividends. You then wait 30 days and sell 1000 shares before the required 60 day period. You then hold the remaining 1000 shares for more than 60 days.
The 1000 shares that you sold after 30 days would be taxed at a normal income rate (depending on what tax bracket you fall in). While the 1000 shares you kept will be taxed at your qualified capital gains tax rate.
Loong story short, you’ll benefit from holding your dividend-paying stocks for a longer period of time because you’ll pay less in taxes and you’ll get to really see the exponential growth potential that dividend investing can offer you.
And if you want a better understanding of how income tax brackets work, you can check out our article where we go in-depth and tackle common misconceptions about income taxes.
The completely legal way to avoid taxes on your dividends
You think you can guess the “secret” to avoiding taxes on your dividends?
We’ll give you a hint.
It rhymes with, “Invest in a Goth IRA account.”
That’s right. If you invest in dividend-paying stocks in your Roth IRA, you’ll be able to avoid taxes on your dividends entirely.
You can choose any type of IRA account to avoid taxes and set yourself up for your long-term finances. But you may also want to consider talking to a financial planner because it’s also important to have a mixture of taxable and tax-free investments in your portfolio according to financial professionals.
At the end of the day, it would be wisest to talk to a tax professional or financial advisor about any questions you have about your dividend taxes and long term planning.
A financial planner will be able to help you look at your investing decisions and guide you on a plan for your financial future.
If you’re investing in a dividend-paying stock, then you’ll most likely be in it for the long run since dividend taxes favor long-term stockholders.
We hope you have a confident understanding of how dividends are taxed after reading this article. Taxes can be a confusing topic, so feel free to share this article with a friend or on social media so your friends can potentially save on their dividend taxes just like you!