What are dividends? What are the taxes on dividends?
Dividends are payments to shareholders by a corporation. Regular dividends are commonly distributed as cash, but they also may be paid out as stocks, stock options, property, services, or debt payments.
Dividends are taxable, and you must report all of your dividend income on your tax returns. Different types of dividends have taxes assessed in different ways, and it is important for you to understand the dividend tax rate that you might have to pay.
Are there different dividend tax rates? What about double taxation?
Qualified dividends are paid during the tax year by domestic corporations and qualified foreign corporations. These fall under the capital gains tax, and the dividend tax rate that investors have to pay depends on their incomes and tax brackets.
Nonqualified or ordinary dividends are the most common type of distribution from a mutual fund or from a corporation. These are treated as ordinary income because they are paid out of the earnings and profits. Nonqualified dividends are taxed at the ordinary income tax rate for the different tax brackets.
The potential for double taxation is also an important concept to understand when paying taxes on dividends. Double taxation happens when you pay income taxes twice on the same source of your earned income such as at both the corporate and personal level. Double taxation normally occurs in international trade.
Double taxation often happens because corporations are considered to be separate legal entities from their shareholders. The corporations pay taxes on their annual earnings before they pay out the dividends to their shareholders. The shareholders’ dividends payments then incur income tax liabilities for the shareholders, leading to double taxation for the same source of income.
Companies paying dividends
Companies use dividends as a method to give back to their shareholders. Approximately 84% of the companies on the S&P 500 index pay dividends, which are usually paid by larger companies.
More than 9 million returns reported taxable gains totaling more than $605 billion. This statistic shows the importance of knowing how you will be taxed on your investments and how you should try to look ahead and plan in order to minimize your taxes on dividends.
What are ordinary/nonqualified dividends?
If a company has excess earnings, the board of directors might decide to pay a dividend to its common shareholders. This amount will be stated together with a date that it will be paid. Typically, a company will determine whether to pay a dividend after it issues its quarterly income statement and conducts a review of its financials.
Dividends are assets that are paid out of the profits of a corporation to the stockholders and are not assessed as capital gains. Ordinary dividends are not considered to be capital gains. Dividends that you receive are ordinary dividends unless the corporation or mutual fund specifically states otherwise. Taxes on dividends that are ordinary are assessed at the ordinary income tax rates for the different tax brackets.
What are qualified dividends?
Qualified dividends are dividends that meet specific IRS requirements. The IRS requires that you must hold shares for a minimum amount of time to benefit from the lower taxes in dividends for qualified dividends.
For common stock, you must hold your investment for more than 60 days during the 121-day period. That begins 60 days before the ex-dividend date, which is the date after the dividend has been paid out and after which new buyers would be eligible to receive future dividends. For preferred stock, you must hold it for more than 90 days during a 181-day period that begins 90 days before the ex-dividend date.
If the holding period is not met, then the dividend is unqualified and is taxed at the normal income tax rate. For qualified dividends, the taxes on dividends are subject to the same 0%, 15%, or 20% tax rate that applies to the long-term capital gains rate for the various tax brackets.
Most regular dividends are qualified. In addition to the waiting periods, the companies that pay the dividends must be U.S. corporations, certain foreign corporations that regularly trades on a major U.S. stock exchange, or corporations that are incorporated in U.S. territories.
Dividends and tax brackets
To better understand the taxes on dividends, here is a simple tax rate table to help you:
Tax brackets for single taxpayers
|Income tax bracket||Tax rate||Capital gains tax rate|
|$0 – $9,700||10%||0%|
|$9,701 – $39,375||12%||0%|
|$39,376 – $39,475||12%||15%|
|$39,476 – $84,200||22%||15%|
|$84,201 – $160,725||24%||15%|
|$160,726 – $204,100||32%||15%|
|$204,101 – $434,550||35%||15%|
|$434,550 – $510,300||35%||20%|
This table reveals why it is better to have dividends that are qualified than nonqualified because the taxes on dividends that you will have to pay will be much lower. The taxes for qualified dividends are the same rates that are used for capital gains taxes.
Various tax rates apply to determine the taxes on dividends that are qualified of 0%, 15%, or 20%, depending on your income. For estates and trusts, dividends are taxed at 15%. Those whose income tax rates are 10% or 15% will pay nothing in taxes that are qualified dividends. This means that dividends that are qualified are tax-free for people who have lower incomes.
However, the short-term capital gains tax rates apply if you own an investment for a year or less. These rates are taxed at the same rate as your ordinary income. This means that it is better to hold on to your investments for longer than a year to take advantage of the lower long-term capital tax rates.
The dividends that are nonqualified are taxed at your ordinary income tax rate, which is higher than the capital gains tax rate. Dividends that are paid out by real estate investment trusts, master limited partnerships, employee stock options, tax-exempt companies, savings accounts, money market accounts, and one-time dividends are all examples of nonqualified dividends.
The taxes on dividends for dividend reinvestment plans or DRIPs still must be paid. These involve using your cash dividends to acquire additional shares of the same company. Some companies modify their DRIPs to allow shareholders to purchase additional shares of stock below their market prices. The difference between the cash that is reinvested and the fair market value of the stock is then taxed as ordinary dividend income.
You must report your dividend income, including dividends of more than $10 from any entity. You will receive Form 1099-DIV stating the amount that you received from each company that paid dividends to you.
If you receive more than $1,500 of taxable interest or ordinary dividends, you need to report them on Schedule B. For trust, estate, or S-corporation dividends, you will receive a Schedule K-1, which will tell you the amount of the dividends that are subject to taxes.
If you receive dividends in any amount, you should still report your dividend income on your tax return. Dividends that are reinvested to purchase stock are still subject to the taxes on dividends.
Ways to limit dividend taxes
There are some ways that you can minimize the dividend taxes that you might otherwise have to pay, including tax loss harvesting and other methods. Time the sale of your investments so that it occurs when it is the most advantageous to you. You will want to make sure to time it so that you do not pay capital gains taxes on the increase in their value until the sale of the investment.
Hold onto your investments for longer than a year so that your dividend tax rate will equal your long-term capital gains tax rate. However, do not hold onto a bad investment solely to get lower taxes on dividends.
You can use tax loss harvesting at the end of the year to offset your capital losses against your capital gains. Under the wash sale rule, if you trade or sell securities at a loss, and, within 30 days prior to or after the sale, you purchase substantially identical stocks in a taxable trade, you will not be able to deduct the losses related to your wash sale.
If you can, try to match your capital gains with a lower income year to take advantage of the lower rates for lower tax brackets. Make certain that you take advantage of retirement investments accounts like IRAs or 401(k) plans that offer tax-free or tax-deferment because doing so can help you to avoid paying taxes now. Finally, you can avoid dividend taxes by investing in stocks that do not pay dividends.
Some companies pay dividends in the form of additional company shares. That means that the taxes on dividends will not be owed until the stock is sold unless you have the option to choose between stock or cash dividends. If you have the choice, you will be taxed on your dividends even if you choose stock dividends.
A capital dividend account or CDA is a tax-free dividend account that is created by companies for their shareholders. The capital dividends come from paid-in capital rather than from retained earnings. However, CDAs are uncommon.
Being cognizant of your dividend tax rate, the potential for double taxation, dividend reinvestment and ways that you can lower your taxes is important. When you build retirement wealth with your dividends at M1 by automatically engaging in dividend reinvestment, your cash always goes to work instead of sitting idly in your account.
How minimizing taxes through M1 Finance works
M1 Finance is an online brokerage with an investment platform and a mobile app. It allows you to move your tax-free or tax-deferred IRA account to M1 and pay nothing on fees. M1 offers award-winning investment tools that enable faster growth of your money automatically while reducing your tax burden.
M1 uses built-in tax efficiency to help to reduce the amount of money that you might owe on your taxes automatically. You can also invest in your IRA without paying all the costs, commissions, and fees that many brokerage firms charge. Investing in M1 Finance allows you to save more money effortlessly.
Simple, free investing with M1 Finance
It is simple to open your investment account with M1 Finance. You can fill out the sign-up form online and then create your own custom portfolio by choosing your stocks. If you are not comfortable with building your own portfolio, you can select from over 80 expertly-created investment portfolios. These portfolios were created to meet different risk levels, goals, and time horizons for investing.
The investment platform through M1 Finance has an intuitive design that helps investors of all levels to be able to access its automation in a straightforward way at any time. M1 Finance does not charge any management fees or commissions, which means that your money could potentially grow faster over time.
The platform also helps with time savings by dynamically rebalancing your portfolio and conducting automatic dividend reinvestments for you. This helps your portfolio to stay on track automatically so that it is continually working for you to help you to reach your goals. M1 Finance combines important principles of investing with technology to make the investing process simpler and to allow you to build your wealth without giving it too much thought. To learn more about the dividend tax rate for different tax brackets and how to minimize it, get started investing today or call us at 312-600-2883.
M1 Finance and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.