As a dividend growth investor or an income investor taxes are a reality. The IRS considers dividends to be income and thus they are subject to taxes. This is the case even if you reinvest all your dividends through a direct reinvestment plan or ‘DRIP’ back into the same company. But fortunately, taxes on dividends can be lower than taxes on your ordinary income from your regular salary if you are receiving qualified dividends. Obviously, this is a good thing. You can create a passive dividend income stream in retirement that is taxed at a lower rate than your regular salary. I will go over an example later in the article. But the main point is that taxes on dividends are treated somewhat differently than taxes on ordinary income.
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History of Qualified Dividends
Qualified dividends did not always exist. In context of dividend investing they are a relatively new concept and category of dividend. In 2003, tax cuts were signed into law. Before this law was implemented, all dividends were taxed at the same rate as regular income. But the Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced all taxpayers’ personal income tax rates and cut the tax rate on qualified dividends from the ordinary income tax rates to the lower long term capital gains tax rates. The long term maximum capital gains tax was reduced from 20% to 15%. A tax rate of 5% was established for taxpayers in the two lowest ordinary income tax brackets of 10% and 15%.
At the time, the thinking was that differences in tax rates incentivized companies not to pay dividends. Instead, companies were being encouraged to conduct share repurchases or to hold cash. Recall, that this was shortly after the dot-com boom, which saw a huge surge in share buybacks and a pretty low percentage of companies paying dividends. Share buybacks were not taxed. In addition, many companies just simply held cash.
The new category of qualified dividends and tax rates had sunset provisions. The Tax Increase Prevention and Reconciliation Act of 2005 prevented the sunset provisions from taking effect. It also lowered the 5% tax rate to 0% on the two lowest ordinary income tax brackets.
The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 extended the category of qualified dividends for two more years. Finally, in 2013, The American Taxpayer Relief Act of 2012 made qualified dividends a permanent part of the tax code. It also added a 20% tax rate on dividends in the new highest 39.6% ordinary income tax bracket. The net effect is that the taxes on your dividends are now always lower than taxes on your regular income or salary.
Creating a lower qualified dividend tax rate that was equal to the long term capital gains tax rate should ideally have benefitted long term shareholders interested in dividends and reducing taxes. Whether this worked or not can probably be debated. However, many tech companies that did not pay a dividend or only paid a small dividend, such as Apple (AAPL), Microsoft (MSFT), Intel (INTC), Cisco (CSCO), and others now pay a growing dividend with a decent yield.
What are Qualified Dividends?
The tax rate for dividends depends on whether the dividends are qualified or non-qualified. Qualified dividends are taxed at the long-term capital gains rate, which is lower than the tax rate on regular income. Non-qualified or ordinary dividends are taxed at your regular income tax rate, which is typically a higher rate.
What are qualified dividends? In order to be considered a qualified dividend the dividend must meet the following criteria:
- 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 have been held for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date
- For preferred stock, the stock must be held for more than 90 days during the 181-day period beginning before the ex-dividend date
What are Ordinary or Non-Qualified Dividends?
Ordinary or non-qualified dividends are pretty much everything else. These are taxed at the regular income tax rate, which is typically higher than the capital gains rate. This can include dividends paid out by real estate investment trusts or REITs, master limited partnerships or MLPs, and other pass-through entities. Dividends paid on employee stock option plans and by tax-exempt companies are non-qualified. Interest from savings accounts, money market accounts, CDs, and bonds are taxed at your regular income tax rate. Dividends received in Individual Retirement Accounts or IRAs are also non-qualified. Special dividends are also non-qualified.
There are exceptions but it gets complicated pretty fast, so we won’t go into those details in this article.
What are the Qualified Dividend Tax Rates?
The differences in federal tax rates between non-qualified or ordinary dividends and qualified dividends can be significant, especially at higher income levels. The table below is the federal tax rate for single filers in 2021. The rates will remain the same in 2022 but the income thresholds will increase slightly to account for inflation.
|Tax Bracket||Tax Rate on Regular Income||Tax Rate on Qualified Dividends|
|$9,951 to $40,400||12%||0%|
|$40,401 to $40,525||12%||15%|
|$40,526 to $86,375||22%||15%|
|$86,376 to $164,925||24%||15%|
|$164,925 to $209,425||32%||15%|
|$209,426 to $444,850||35%||15%|
|$445,851 to $523,600||35%||20%|
The table below is the federal tax rate for joint filers in 2021. The tax rates will remain the same in 2022 but the income thresholds will increase slightly to account for inflation.
|Tax Bracket||Tax Rate on Regular Income||Tax Rate on Qualified Dividends|
|$19,901 to $80,800||12%||0%|
|$80,801 to $81,050||12%||15%|
|$81,051 to $172,750||22%||15%|
|$172,751 to $329,850||24%||15%|
|$329,851 to $418,850||32%||15%|
|$418,851 to $501,600||35%||15%|
|$501,601 to $628,300||35%||20%|
How Do You Determine if Your Dividends Are Qualified or Not?
It all sounds complicated. You are likely asking yourself; how do I know if my dividends are qualified or not? Luckily, you do not have to make that determination. Instead your brokerage firm must do so. You should receive a 1099-DIV at the end of the year listing all your dividends providing your dividends are over $10. The form should also state whether a dividend is qualified or not. Line 1a of your form 1099-DIV should list the total amount of non-qualified or ordinary dividends and line 1b will list the total amount of qualified dividends. The 1099-DIV will also list your qualified dividends by company and when they were paid.
If you own shares in an MLP your dividends will be reported in a Schedule K-1. A Schedule K-1 is also used if you receive dividends from a trust, estate, partnership, LLC, or S corporation. But you should also receive a 1099-DIV to list the dividends that you have received.
These forms are required to be sent to you by January 31st by the IRS.
Investing in Dividends is Tax Efficient
Investing in dividends is more tax efficient than investing in bonds, money markets, savings accounts or CDs. Of course, there is more risk investing in stocks that pay dividends compared to investing in savings accounts, CDS, or money markets. Stocks fluctuate in value and you can lose your initial principle. That said, let’s take a look at an example of the better tax efficiency with stocks that pay dividends compared to a CD.
Let’s assume that you have $100,000 invested in a CD that pays 3% and $100,000 investing in dividend paying stocks that yields 3%. What is the impact of taxes on the interest income and dividends of the respective investments? Three percent of $100,000 is $3,000. In the case of the CD, the $3,000 is taxed as ordinary income. If you are earning $50,000 per year then your tax rate is 22%. So, you would have to pay $660 in taxes. This gives $2,340 and an after-tax yield of 2.34%. In the case of qualified dividends, the $3,000 is taxed at the long term capital gains rate of 15%. So, you would pay $450 in taxes. This gives $2,550 and an after-tax yield of 2.55%. The table below summarizes these results.
You can see that qualified dividends are more tax efficient than interest income or even ordinary dividends. The 0.21% difference seems small, but it can add up over time. Imagine that if the extra $210 is reinvested and you leverage the power of compounding.
Dividends in Retirement Accounts
It is possible to have dividend paying stocks in your retirement accounts assuming that your plan permits it. The main advantage to this is that the dividends can be reinvested and compound tax free. You will still need to pay taxes on your contributions or your withdrawals depending the type of retirement account. But your money will grow tax-free within the retirement account.
Final Thoughts on Dividends and Taxes
In my opinion dividends matter because they are a great way to generate a passive income stream. The dividends are for the most part predictable and they tend to grow over time in well managed companies. This results in a rising dividend income stream. However, taxes are a reality of investing in dividend paying stocks since the IRS views dividends as taxable income. Fortunately, qualified dividends are tax efficient compared to regular taxable income and non-qualified dividends. Qualified dividends are taxed at the lower long term capital gains tax rate as opposed to the higher regular income tax rate. This means that the after-tax yield is higher, and you get to keep more of the money compared to some other investments. If that money is reinvested over time it can compound, which is an advantage of dividend growth investing.
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