• November 28, 2022

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Dividend income is taxable, but the tax rate is determined by a handful of factors. The most important factor is whether the dividend is qualified or ordinary (or non-qualified), as qualified dividends are taxed at the long-term capital gains rate, instead of rate on regular income. Qualified dividend stocks are attractive investments because the low-tax dividends can combine with the stock’s appreciation to generate impressive returns.

Tax Treatment For Dividends

Qualified dividends are taxed at the long-term capital gains tax rate, which is 7% to 22% lower than the tax rate on regular income. According to the Internal Revenue Service (IRS), ordinary dividends are the most common type of distribution. A distribution must meet three criteria to become a qualified dividend.

The first criterion is that the dividends must have been paid by a U.S. corporation or a qualified foreign corporation. Qualified foreign corporations include companies that are incorporated in a U.S. company’s possession, those that are based in countries that have income tax treaties with the U.S., or a company whose stock is tradeable on a U.S. securities exchange.

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The second criterion is that the receiver of the dividend payment must meet the holding period requirements. This requires the investor to have held the stock for at least 60 days during the 121 days beginning 60 days before the ex-dividend date. For preferred stock, the investor must have held the stock for at least 90 days during the 181 days starting 90 days before the ex-dividend date. The ex-dividend date is the day before which an investor must purchase a stock to qualify for a dividend payment.

The final criterion is that the dividend must not fall under a list of disqualifying factors described by the IRS. Some of the most common disqualifiers include dividends on shares that are being used for options trading or short sales. Distributions by master limited partnerships (MLPs) and real estate investment trusts (REITs) are disqualified, as are dividends on employee stock options.

For a complete list of the specific dividends that don’t qualify, see IRS Publication 550.

Investors can find whether their dividends are qualified or ordinary by checking their IRS Form 1099-DIV, which is typically provided by a broker.

Tax Rate

The long-term capital gains tax rate for qualified dividends is either 0%, 15% or 20%, depending on the investor’s income. Those earning less than $79,999 per year pay 0%. Those earning between $80,000 and $441,449 pay 15%. Anyone earning more than $441,500 annually pays 20% tax on qualifying dividends.

Unqualified dividends are taxed at the short-term capital gains tax rate, which is the same as the tax rate on regular income. The current rates range from 10% to 37%, depending on the investor’s income level.

How To Avoid Tax On Dividends

There are three ways to avoid taxes on dividends.

The first is if the distribution recipient’s taxable income is in one of the lowest three taxable income brackets, which includes taxable earnings below $79,999. All qualified dividend payments below that income are eligible for a 0% tax rate.

Second, dividend payments from stocks held in tax-deferred accounts don’t require dividend tax. The most common tax-deferred accounts for these securities are a Roth IRA, 401(k), and a college savings plan.

The final way to avoid tax on dividends is if the dividend is a non-taxable return of capital, meaning the investors are receiving some of the money they invested, rather than a distribution of earnings. These payments are technically not dividends in the eyes of the IRS. These distributions are only taxed when the stockholder sells their shares.

Five Market-Beating Dividend Stocks to Whip Inflation

Many investors may not realize that since 1930, dividends have provided 40% of the stock markets total returns. And what is even more less known is its outsized impact is even more acute during inflationary years like the one we’re having now, a whopping 54% of shareholder gains. If you’re looking to add high quality dividend stocks to hedge against inflation, Forbes’ investment team has found 5 companies with strong fundamentals to keep growing when prices are surging.

Click here to learn more.

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