A great incentive for anyone to invest their money into a company is the promise of earning dividends. Many companies pay dividends to their shareholders, who receive this money for simply owning a share in said company. Before we dive into the world of finance, we need to understand that dividends aren’t free money. Rather, they are viewed as income and therefore are subject to taxation.
This taxation is called the dividend tax rate. Your rate will differ from someone else’s based on what type of dividends you have, how much you make from them, and how much other income you receive. Another factor that determines how much you’ll receive from these dividends is how and when you own them. This can dramatically change your tax rate.
Let’s talk taxes.
The dividend tax rate for 2020
Currently, the maximum tax rate for qualified dividends is 20%, 15%, or 0%, depending on your taxable income and tax filing status. For anyone holding nonqualified dividends in 2020, the tax rate is 37%.
Dividends are taxed at different rates depending on how long you’ve owned the stock. While nonqualified dividends are taxed at the same rate as ordinary income, other dividends are taxed at a lower rate.
Types of dividends
We’ve just used two terms above that need some explaining. Qualified and nonqualified are the two types of dividends you can hold.
In simple terms, qualified dividends are the dividends paid from stocks that you’ve held for a long time and come with the perk of a lower tax rate. These dividends are taxed at the same rate as long-term capital gains. This means that you’ll pay 15% on dividend income, though anyone earning more than $425,900 on their own or $479,000 with their spouse could pay as much as 20%.
On the other hand, anyone earning less than $38,600 on their own or $77,200 with their spouse will pay no tax on their dividend income. These dividend tax rates depend on how much you earn from your main income as well as how long you hold onto your stock. The best advice to avoid having to pay higher dividend tax rates is to hold onto your stocks for a few months minimum.
NOTE: The definition of how long is long enough to deem a stock qualified can rest in a grey area. Usually, if you own the stock for more than 60 days during the 121-day period that began 60 days before the ex-dividend date (the day when you must own the stock to receive the dividend) - the dividend is usually considered qualified.
There are many exceptions to this rule though. For thorough understanding, refer to the IRS Publication 550 for all the tax details your heart desires.
Nonqualified (also referred to as ordinary) dividends are classified as dividends that don’t meet the standard of a qualified dividend. These dividends are taxed the same as an investor’s personal income tax bracket. For example, if you’re within the 27% tax bracket, you’ll pay a 27% dividend tax on your nonqualified dividends.
Although nonqualified dividends are taxed at a lower rate, there are still some instances where an investor will pay a higher tax rate on dividends regardless of their type. For example, dividends from shares of real estate investment trusts will always be taxed as ordinary income.
How to report dividend income on your taxes
The first step in reporting your dividend income on your taxes is to consult your broker. They’ll give you a 1099-DIV tax form that indicates how much you earned from your dividends. This form will also tell you whether your dividends are qualified or nonqualified. You’ll use this info to complete your 1040 (your tax return). If you received more than $1500 in dividends for the year, you’ll need to fill out a Schedule B form as well and attach it to your 1040.
Remember that even if you didn’t take your dividend in cash, you’re still responsible for reporting it. Additionally, you’ll still need to report any stock you sold over the course of the year.
How to avoid dividend taxes
If you’re trying to avoid paying taxes on your dividends, a good option is to put your dividend-earning shares into a retirement account. Dividends in a 401(k) or Roth IRA will grow tax-free. Under a 401(k) or a traditional IRA, investors can avoid paying a tax until they take out money once they retire. If you open a Roth IRA, your money will be taxed now, but you won’t pay any additional taxes when you retire.
Investing in a company and earning dividends is a great source of extra income. Doing so is popular among retirees because you do not have to pay tax on income in a retirement account. This is great because retirees can go and reinvest their dividend earnings to grow their savings without the government taxing them.
If you’re unsure what dividends are right for you, consult a financial advisor. Advisors will answer any questions you may have and help you stay up to date on dividends and taxes in general.
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Alexa is a former content associate at G2. Born and raised in Chicago, she went to Columbia College Chicago and entered the world of all things event marketing and social media. In her free time, she likes being outside with her dog, creating playlists, and dabbling in Illustrator. (she/her/hers)