Dividend investing is a common practice among stock market investors, especially those with lower risk tolerance. However, to truly understand dividends, it is essential to consider the variables. As part of our Personal Financial Planning 101 series, this article will unpack how dividends are taxed.
What Are Dividends?
When a corporation has excess earnings, instead of reinvesting those funds into the company, the earnings can alternatively be paid as a dividend, similar to a thank you for being part-owner of the company. Dividend payments occur quarterly and are usually provided by larger, more value-focused companies, but any company can issue them if they desire. Dividend amounts and frequencies are not guaranteed since companies may decide to alter or cancel future dividend payments. Yet, dividends are normally offered to attract investors because the company does not expect much growth potential moving forward. Therefore, eliminating or reducing a dividend may hurt the attractiveness of the underlying company from an investment standpoint.
What Determines the Taxation of Dividends?
The taxation of dividends relies heavily on whether the dividend is considered qualified. These requirements mainly focus on whether the company is domestic or international if the company complies with U.S. tax laws. There is also a holding period need before the dividends become qualified for the investor. More times than not, the investors will be qualified if an uncompliant international company is not paying them.
Which Dividends are Taxed as Income?
Non-Qualified dividends are taxed as ordinary income. These dividend payments do not qualify for the preferred tax treatment, so they are recorded and taxed at traditional income rates. Qualified dividends offer more value to investors since they are taxed at long-term capital gains rates. This means that those in the lower tax brackets may not need to pay any taxes on their dividend income. Also, those in the higher brackets will be capped at a tax rate of 20%. The growth of the investments may still be taxed at various rates, but the dividend payments will be taxed according to the schedules above. Also, it is essential to note that dividends are taxed regardless if they were paid in cash or automatically reinvested into additional shares.
Taxes on Dividends – Summarized
- When you own a stock, you are part-owner of the company. Some companies pay out dividends as a thank you for being an investor.
- Dividend taxes are due when you receive the dividend payment from the company.
- Dividends can either be Qualified or Non-Qualified depending on the circumstances and details of the paying company.
- Qualified Dividends are taxed at the long-term capital gains tax rate, and Non-Qualified Dividends are taxed as ordinary income.
Want to Learn More?
If you have any questions about taxes, your individual investment portfolio, our 401(k)-recommendation service, or anything else in general, please give our office a call at (586) 226-2100. For helpful tips on other popular financial topics, check out our articles on Meme Stocks, US Inflation Rate, Capital Gains Tax, and When to Start Saving for Retirement. Please feel free to forward this commentary to a friend, family member, or co-worker. If you have had any changes to your income, job, family, health insurance, risk tolerance, or overall financial situation, please contact the Team at Summit Financial. We hope you learned something today. If you have any feedback or suggestions, we would love to hear them.
Zachary A. Bachner, CFP® with contributions by Robert L. Wink, Kenneth R. Wink, and James D. Wink.