A common question for many income investors is, "How are dividends taxed?"
After all, investing for dividends is normally not the kind of strategy that doubles your money in a short period of time. Consider that the yield of the typical stock in the S&P 500 index (.SPX) at just 1.9% as of this writing.
As such, it's not uncommon for a portfolio of even the very best dividend stocks to generate less than 3% annual returns via dividend payments alone. That means that even a small margin paid out as a dividend tax can result in a serious chunk of your total distributions.
But thankfully, most Americans won't have an onerous burden when it comes time to pay their dividend tax to Uncle Sam. In fact, if you're an investor of modest means there's a chance that you won't pay a single penny in taxes at all.
When are dividends taxed at zero, and when do you have to pay up? Well, the answer is different for each portfolio and it's crucial to know what rules apply to your personal situation.
The first question you need to ask yourself is whether you're receiving a "qualified" dividend or an "unqualified" dividend in the eyes of the Internal Revenue Service and its dividend tax rules. You can read Publication 550 for complete rules on the subject of investment income, but generally speaking a qualified dividend must be:
- Paid by a U.S. corporation or qualifying foreign entity. The first part of that is simple, since popular dividend stocks like Johnson & Johnson (JNJ) are obviously headquartered here. But foreign stocks are also fairly easy to identify as "qualified" dividend payers if they are listed on a major exchange like the New York Stock Exchange or Nasdaq (.IXIC) as an American Depositary Receipt, also known as an ADR.
- Specifically seen as a dividend by the IRS. Some entities may use the word dividend in their materials, but it's the IRS's point of view that matters most. Profit sharing from a business partnership or kickbacks from co-ops or other tax-exempt organizations may not count.
Thankfully, the vast majority of publicly traded corporations know better than to use the word "dividend" if it implies a qualified payout and instead opt for words like "distribution" – but make sure you read the fine print of your investments to be sure how your dividends are taxed.
And of course, at the end of the year you will receive a formal Form 1099-DIV form that is specifically required by the IRS to keep track of qualified dividends. This form is crucial, since it includes the company's recordkeeping on its dividends, and is a must-have for any self-reported dividend income from any source.
If you don't see a 1099-DIV form that flags the income as qualified, you may not meet the IRS requirements. If that's the case, your unqualified dividend is simply seen as another source of ordinary income and will be taxed at your relevant tax bracket just like a paycheck.
If you have qualified dividends and the appropriate paperwork, however, then your dividend tax is one of three figures – 20%, 15% or nothing at all.
The top 20% bracket on qualified dividends is only shouldered by the extremely well-off. Specifically, you must record $488,851 or more in taxable income as of the 2019 tax requirements.
The next step down, at a 15% rate, is anyone who records $78,751 to $488,850 in taxable income.
If you happen to record $78,750 or less in taxable income, then you pay zero tax on your qualified dividends.
This last bracket that pays nothing most commonly includes retirees who get only a modest amount of income via a pension or Social Security and are supplementing their budget with dividends. But there are cases when someone with modest ordinary income but a tremendous portfolio of dividend stocks qualifies for this bracket.
If you're still wondering how dividends are taxed, then it may be worthwhile to seek out a professional preparer to avoid any mistakes.
Each taxpayer's situation is unique and every investment portfolio is different, and sometimes a trained expert is the easiest way to figure things out. That may cost a small fee come tax time, but may save you a bundle if you find out your dividends are taxed at a higher rate when they don't have to be.
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