Dividends are taxed in different ways — here's h
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Posted On: 02/03/2024 4:12:51 PM
Dividends are taxed in different ways — here's how to figure what you owe on your stocks' payouts
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.
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.
What is a dividend?
A dividend is a payment made to a company's stockholders. Business and financial entities like publicly traded companies, master limited partnerships, and real estate investment trusts issue dividends as a means of distributing their after-tax earnings to investors. Mutual funds and exchange-traded funds pay dividends as well.
Determined by a company's board of directors, dividends are calculated on a per-share basis. Usually, they're in the form of cash and deposited directly into an investor's financial account.
However, companies sometimes pay dividends with new shares of stock. And, in some cases, companies offer dividend reinvestment programs (DRIPs) that allow investors to apply the dividend toward the purchase of additional stock, often at a discounted price.
In the US, companies usually pay dividends each quarter. But payments can also occur monthly or semi-annually.
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, 2022.
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, 2022. So the ex-dividend date was May 9, 2022.
Since you purchased the shares more than 60 days prior to the ex-dividend date (May 9, 2022), 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 do I know if my dividends are qualified or not?
Don't worry; you don't have to keep track of ex-dividend dates and figure out which dividends are and aren't qualified on your own. Around January 31 of each year, you should receive Form 1099-DIV from any company or brokerage that paid you at least $10 in dividends or other distributions during the prior year. Your total dividends are shown in Box 1a of Form 1099-DIV, and qualified dividends appear in Box 1b.
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.
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 $44,625 or less in 2023 ($47,025 or less for 2024) 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 ETFs 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.
Stocks that pay dividends
Most dividend-paying companies are large-cap, well-established, and well-endowed businesses. These mature corporations don't need to reinvest earnings back into the business, the way small- and mid-cap companies or startups often do.
Industry sectors that are rich in dividend-paying companies — and whose companies pay rich dividends — include:
Telecommunications
Energy/Basic materials
Financial
Healthcare /pharmaceuticals
Utilities
Consumer staples
Kinds of dividends
Although all dividends come from the same source — the company earnings — the nature of their payouts depends on the class of shares you hold.
Common dividends are paid to owners of a company's common stock. They can fluctuate in their amount each quarter (or whenever they're issued). It's in a company's interest to keep them increasing, or at least constant, but there are no guarantees.
Preferred dividends are paid to owners of preferred stock. These are the same fixed amount; they don't fall, but they don't rise either. However, should a company run into financial trouble, preferred dividends hold priority over common dividends in the pecking order of payouts.
Occasionally, companies issue a special dividend — an extra payout to common stockholders. Special dividends usually are issued by firms who have either stockpiled a lot of cash over the years or experienced a windfall — from spinning off a subsidiary, for example. While often much larger than the regular variety, this "extra" dividend is a one-time thing.
Cash dividends vs. stock dividends: At a glance
Cash dividends are payments made in cash to shareholders based on the number of shares they hold.
Stock dividends are payments to shareholders made in the form of additional shares of stock.
Most companies pay dividends in cash. When a company declares a dividend, shareholders who own stock as of a date specified in the announcement are entitled to the payment. The payments are made on a per-share basis. For example, if a company you owned 1,000 shares declared a dividend of 50 cents per share, you would be paid $500.
If you are looking for income from your stock on a regular basis, cash dividends are among the best sources. Dividends are normally declared quarterly, and investors will receive quarterly cash payments. This can be seen as a sort of reward for investing in the company. However, not every company issues cash dividends.
A stock dividend is when the company pays the shareholders with additional shares of stock. This kind of dividend is uncommon. If you don't need income or immediate cash, you can defer the income by selling the stock later. The best scenario is that the stock appreciates in value over this time. The risk is that the stock declines in value.
Stock dividends are typically issued by smaller companies looking to increase liquidity and the number of shares in the market, says George Metrou, an equity portfolio manager at Morningstar Investment Management.
"However, a company paying a stock dividend could be a sign of financial distress and it may signal they are trying to conserve cash," Metrou says. "This is especially true if they were paying a cash dividend and switched to a stock dividend.
How are dividends evaluated?
Beyond the basic dollar amount, dividends are evaluated in a few different ways.
Dividend yield
In terms of valuing a dividend, investors look at a stock's dividend yield — the amount of the annual dividend divided by the stock price on a particular date. Measuring the dividend yield levels the playing field when comparing stocks and their dividend payouts.
For example, a stock with a $10 share price and a quarterly payout of 10 cents per share yields a 4% dividend. At the same time, a $100 stock that pays $1 per share, also on a quarterly basis, likewise yields a 4% dividend.
Yield and stock prices relate inversely to each other. As dividends increase, stock prices decrease. So dividend yields go up in one of two ways:
A rise in the dividend payout: A company that pays a $4 dividend on a stock valued at $100 has a 4% dividend yield. A 10% increase in the dividend to $4.40 changes the dividend yield to 4.4% if the stock price remains static.
A decrease in the stock price: Say, for instance, the price of a stock with a $4 dividend payout falls from $100 to $90. Without a change in the amount of the dividend, the 4% dividend yield climbs to just over 4.4%.
Dividend payout ratio
Beyond looking at a stock's dividend yield, however, savvy dividend investors look even more closely at the dividend payout ratio to gain a quick assessment of their reliability.
The payout ratio measures the portion of a company's net income that goes toward shareholder dividend payments. The higher the payout proportion, the lower the margin of safety. As a rule of thumb, investors look for payout ratios that fall below 80% of a company's net income.
Dividend-paying companies also incentivize investors seeking prudent financial vehicles. While stock investing often triggers capital gains implications, IRS accounting rules around dividend payments create a somewhat kinder, gentler tax hit. Rather than paying a higher capital gain rate, ordinary income rates apply to dividend payouts.
What is a dividend reinvestment plan (DRIP)?
Dividends for a company are typically paid out every quarter, as long as you were holding the stock before the ex-dividend date, which is the cutoff date at which you need to hold a stock in order to receive the dividend. There can also be a minimum stock-holding requirement to earn a dividend.
A dividend reinvestment plan (DRIP) allows you to invest any dividends you received from a security back into it, instead of receiving it as a cash deposit in your brokerage account. They can be helpful for long-term investors looking to double down on an investment with lower costs than normal. But even though the dividends are reinvested, they're still subject to capital gains taxes.
DRIPs operate using an investing strategy called dollar-cost averaging, in which you invest a certain amount of money at regular intervals, which averages out the costs of investing while minimizing the risk and volatility you're exposed to.
Important dividend dates to know
There are some key dates surrounding dividends — especially pertaining to when a stockholder qualifies for them.
Announcement date: The day management declares a dividend, which requires shareholder approval.
Record date: The cutoff date, established by the company, that establishes share owner's eligibility for a dividend. This is when you must be on the company's books as a stockholder to receive the dividend.
Ex-dividend date: The date, based on stock exchange rules, by which a shareholder must own stocks in order to receive a dividend for the payout period. It's usually set one business day before the record date. Shareholders who own a stock one business day before the ex-date receive a dividend payout. Shareholders who buy the stock on the ex-date or after — don't.
Payment date: The date on which a company issues dividend payments, and shareholders receive the money in their brokerage accounts.
Source:
https://www.businessinsider.com/personal-fina...-are-taxed
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.
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.
What is a dividend?
A dividend is a payment made to a company's stockholders. Business and financial entities like publicly traded companies, master limited partnerships, and real estate investment trusts issue dividends as a means of distributing their after-tax earnings to investors. Mutual funds and exchange-traded funds pay dividends as well.
Determined by a company's board of directors, dividends are calculated on a per-share basis. Usually, they're in the form of cash and deposited directly into an investor's financial account.
However, companies sometimes pay dividends with new shares of stock. And, in some cases, companies offer dividend reinvestment programs (DRIPs) that allow investors to apply the dividend toward the purchase of additional stock, often at a discounted price.
In the US, companies usually pay dividends each quarter. But payments can also occur monthly or semi-annually.
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, 2022.
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, 2022. So the ex-dividend date was May 9, 2022.
Since you purchased the shares more than 60 days prior to the ex-dividend date (May 9, 2022), 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 do I know if my dividends are qualified or not?
Don't worry; you don't have to keep track of ex-dividend dates and figure out which dividends are and aren't qualified on your own. Around January 31 of each year, you should receive Form 1099-DIV from any company or brokerage that paid you at least $10 in dividends or other distributions during the prior year. Your total dividends are shown in Box 1a of Form 1099-DIV, and qualified dividends appear in Box 1b.
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.
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 $44,625 or less in 2023 ($47,025 or less for 2024) 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 ETFs 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.
Stocks that pay dividends
Most dividend-paying companies are large-cap, well-established, and well-endowed businesses. These mature corporations don't need to reinvest earnings back into the business, the way small- and mid-cap companies or startups often do.
Industry sectors that are rich in dividend-paying companies — and whose companies pay rich dividends — include:
Telecommunications
Energy/Basic materials
Financial
Healthcare /pharmaceuticals
Utilities
Consumer staples
Kinds of dividends
Although all dividends come from the same source — the company earnings — the nature of their payouts depends on the class of shares you hold.
Common dividends are paid to owners of a company's common stock. They can fluctuate in their amount each quarter (or whenever they're issued). It's in a company's interest to keep them increasing, or at least constant, but there are no guarantees.
Preferred dividends are paid to owners of preferred stock. These are the same fixed amount; they don't fall, but they don't rise either. However, should a company run into financial trouble, preferred dividends hold priority over common dividends in the pecking order of payouts.
Occasionally, companies issue a special dividend — an extra payout to common stockholders. Special dividends usually are issued by firms who have either stockpiled a lot of cash over the years or experienced a windfall — from spinning off a subsidiary, for example. While often much larger than the regular variety, this "extra" dividend is a one-time thing.
Cash dividends vs. stock dividends: At a glance
Cash dividends are payments made in cash to shareholders based on the number of shares they hold.
Stock dividends are payments to shareholders made in the form of additional shares of stock.
Most companies pay dividends in cash. When a company declares a dividend, shareholders who own stock as of a date specified in the announcement are entitled to the payment. The payments are made on a per-share basis. For example, if a company you owned 1,000 shares declared a dividend of 50 cents per share, you would be paid $500.
If you are looking for income from your stock on a regular basis, cash dividends are among the best sources. Dividends are normally declared quarterly, and investors will receive quarterly cash payments. This can be seen as a sort of reward for investing in the company. However, not every company issues cash dividends.
A stock dividend is when the company pays the shareholders with additional shares of stock. This kind of dividend is uncommon. If you don't need income or immediate cash, you can defer the income by selling the stock later. The best scenario is that the stock appreciates in value over this time. The risk is that the stock declines in value.
Stock dividends are typically issued by smaller companies looking to increase liquidity and the number of shares in the market, says George Metrou, an equity portfolio manager at Morningstar Investment Management.
"However, a company paying a stock dividend could be a sign of financial distress and it may signal they are trying to conserve cash," Metrou says. "This is especially true if they were paying a cash dividend and switched to a stock dividend.
How are dividends evaluated?
Beyond the basic dollar amount, dividends are evaluated in a few different ways.
Dividend yield
In terms of valuing a dividend, investors look at a stock's dividend yield — the amount of the annual dividend divided by the stock price on a particular date. Measuring the dividend yield levels the playing field when comparing stocks and their dividend payouts.
For example, a stock with a $10 share price and a quarterly payout of 10 cents per share yields a 4% dividend. At the same time, a $100 stock that pays $1 per share, also on a quarterly basis, likewise yields a 4% dividend.
Yield and stock prices relate inversely to each other. As dividends increase, stock prices decrease. So dividend yields go up in one of two ways:
A rise in the dividend payout: A company that pays a $4 dividend on a stock valued at $100 has a 4% dividend yield. A 10% increase in the dividend to $4.40 changes the dividend yield to 4.4% if the stock price remains static.
A decrease in the stock price: Say, for instance, the price of a stock with a $4 dividend payout falls from $100 to $90. Without a change in the amount of the dividend, the 4% dividend yield climbs to just over 4.4%.
Dividend payout ratio
Beyond looking at a stock's dividend yield, however, savvy dividend investors look even more closely at the dividend payout ratio to gain a quick assessment of their reliability.
The payout ratio measures the portion of a company's net income that goes toward shareholder dividend payments. The higher the payout proportion, the lower the margin of safety. As a rule of thumb, investors look for payout ratios that fall below 80% of a company's net income.
Dividend-paying companies also incentivize investors seeking prudent financial vehicles. While stock investing often triggers capital gains implications, IRS accounting rules around dividend payments create a somewhat kinder, gentler tax hit. Rather than paying a higher capital gain rate, ordinary income rates apply to dividend payouts.
What is a dividend reinvestment plan (DRIP)?
Dividends for a company are typically paid out every quarter, as long as you were holding the stock before the ex-dividend date, which is the cutoff date at which you need to hold a stock in order to receive the dividend. There can also be a minimum stock-holding requirement to earn a dividend.
A dividend reinvestment plan (DRIP) allows you to invest any dividends you received from a security back into it, instead of receiving it as a cash deposit in your brokerage account. They can be helpful for long-term investors looking to double down on an investment with lower costs than normal. But even though the dividends are reinvested, they're still subject to capital gains taxes.
DRIPs operate using an investing strategy called dollar-cost averaging, in which you invest a certain amount of money at regular intervals, which averages out the costs of investing while minimizing the risk and volatility you're exposed to.
Important dividend dates to know
There are some key dates surrounding dividends — especially pertaining to when a stockholder qualifies for them.
Announcement date: The day management declares a dividend, which requires shareholder approval.
Record date: The cutoff date, established by the company, that establishes share owner's eligibility for a dividend. This is when you must be on the company's books as a stockholder to receive the dividend.
Ex-dividend date: The date, based on stock exchange rules, by which a shareholder must own stocks in order to receive a dividend for the payout period. It's usually set one business day before the record date. Shareholders who own a stock one business day before the ex-date receive a dividend payout. Shareholders who buy the stock on the ex-date or after — don't.
Payment date: The date on which a company issues dividend payments, and shareholders receive the money in their brokerage accounts.
Source:
https://www.businessinsider.com/personal-fina...-are-taxed
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