It would be understandable to question why an article about minimizing taxes on dividend stocks would appear following the submission of one’s tax forms. The answer is that one needs to plan what they are doing during the tax year before the next form comes due. Hopefully, this article will help with that planning process.
Income from dividends is a category that needs to be understood. Planning for next year’s taxes starts at the beginning of the tax year, so placing this article in April offers a chance to plan for the coming year.
We begin with the possible misconception that dividends are necessarily free money. I use the word “possible” in the context that it is possible, depending upon your circumstances. One needs to consider their tax liability to place themselves in the best of these circumstances.
Dividends that are converted into additional shares of a company through a Dividend Reinvestment Program or broker are subject to taxes like other sources of income. When you receive a dividend, you choose whether to take the cash or reinvest it. The government does not care which path you take, they do, however, want their cut regardless of the choice.
The inception of planning is to consider the issue of qualified dividends. The key is that qualified dividends are taxed at the same rate as long-term capital gains. Whereas regular federal income tax rates can go up to 37%, qualified dividends are taxed at 20%, 15%, or even 0%.
I wrote an article, Qualified vs. Unqualified Dividends, which explains the difference between these two types of dividends. This difference boils down to either being required to pay taxes or potentially not having to pay taxes, so it is significant.
The skinny is that qualified dividends are those that are paid by U.S. corporations, held for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date, and are not under the type listed as unqualified dividends. I will go over these three requirements individually.
Qualified dividends are those that are paid by U.S. corporations
The first requirement that the dividends must be paid by U.S. corporations is self-explanatory but may answer a question by those holding mutual funds. Some tax forms from these funds may show income in both the qualified and unqualified categories, and that would be because the fund holds some foreign companies that offer dividends.
To be a qualified dividend the stock must be held for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date
The second qualification may sound somewhat circuitous but generally means that the IRS requires a minimum holding time. If you buy just before the ex-div date and sell right after receiving the dividend, it no longer is considered qualified.
An example would be where one purchases shares of a company on July 5, the ex-dividend date is July 12 and the shares are sold on August 8. The dividends the investor received would then not be considered qualified dividends because the stock was only owned for 34 days. If the investor had held the shares until November 1, they would have been owned for more than 60 days within the May 13 (60 days before the ex-dividend date) – September 10 (60 days after the ex-dividend date) timeframe, thus the dividends would be considered to be qualified.
There is a short-term dividend strategy called the Dividend Capture Strategy in which this situation needs to be taken into account. In this scheme, the investor purchases a stock just before the ex-div date pockets the dividend, and sells the stock. As this dividend becomes unqualified, full taxes will be imposed, so this needs to be taken into consideration if employed.
Qualified dividends not under the type listed as unqualified dividends
This sounds like one of those commercials that tell you not to take the drug they are advertising if you are allergic to it. The deal is that some categories remove the ability to call a dividend qualified, and most of them you probably will not need to worry about, like employee stock options, dividends from money market accounts, and special one-time dividends that place them in the unqualified category.
The most prominent category in this group would be REITs. This group of investments normally has an enticing dividend yield, but full taxes will be required for them. This means that a portion of those dividends will disappear to taxes, making them less attractive.
Your Tax Bracket
If you are single and earn $445,850 or more in 2021 then congratulations, financially, you are doing considerably better than I am. The good news for the rest of us is that there will be a reduction in the taxes paid on qualified dividends.
To see where you stand, take note of the below table.
2021 Qualified Dividends Tax Brackets
| For single filers with taxable income of | For married joint filers with taxable income of | For heads of households with taxable income of | Tax rate on qualified dividends |
|---|---|---|---|
| $0 to $40,400 | $0 to $80,800 | $0 to $54,100 | 0% |
| $40,401 to $445,850 | $80,801 to $501,600 | $54,101 to $473,750 | 15% |
| Over $445,851 | Over $501,601 | Over $473,751 | 20% |
Earning under $40,400 if you are single ($80,800 as a married couple) means that you will not pay taxes on those qualified dividends. In this particular case, we are finally talking about free money.
Mutual Funds
As noted above, dividends acquired through mutual funds are still subject to taxes. Funds held in IRAs, 401(k)s, or annuities are not taxed while they are in the account, only when the distribution is taken. These funds should take care of themselves as far as taxation is concerned, but we do need to understand something about funds outside of this area.
Taxable events that happen due to the activity of the fund manager are passed along to the shareholder of the fund. You may hold a fund for years, but if the fund manager buys and sells stocks at a higher value, then you are paying taxes on the capital gains, as well as the dividends.
There is something that may not be understood when it comes to the possibility of paying taxes twice on the gains. For instance (looking at a simplified instance), take the example of purchasing $10,000 of a fund, which receives $400 per year in dividends, which are reinvested.
In five years, the fund becomes worth $15,000, and then you sell it. Initially, you may think that you will be paying taxes on the $5,000 gain, but that is not correct. The $2,000 of reinvested dividends ($400 x 5 years) is part of the cost basis, so the taxable gains are not $5,000, but $3,000. Keep this in mind when filling out those tax forms.
Finishing Up
There is rarely a free lunch to be found, but if you are in the lower income tax bracket then you may be able to receive dividends without paying taxes on them. Before making that assumption, however, you need to understand the conditions that could make this possible.
Holding the right class of United States dividend-paying stocks for an appropriate amount of time can make the difference, so examine your holdings, and keep these conditions in mind when considering new purchases.
