Dividends are taxable income. Sure it would be very nice if you get to keep all of it, but Uncle Sam wants his share of it! So, before you start investing in businesses that pay out dividends, you should take into consideration tax consequences.
Qualified vs. nonqualified dividends
First thing first, there are two types of dividends: nonqualified (ordinary) and qualified. They are taxed at different rates. Qualified dividends are taxed at long term capital gain rates of 0%, 15%, and 20%. Nonqualified (ordinary) dividends are taxed at the ordinary income tax rate, at present 37% max.
The Federal income tax bracket 2020
Currently, there are 7 tax brackets. Where you belong to depends on your income and filing status.
How it works: Mary, a single lady making $50,000.00/year, including $1000 in dividends, belongs to the 22% tax bracket. Does that mean that she needs to pay 22% on all of her hard-earned money to the Federal Government? No, because the USA has a progressive tax payment system.
She would pay a 10% income tax on the first $9,875 that she makes, 12% on the difference between $40,125 and $9,875. Her last bracket would be 22%, meaning she is only going to pay that rate on the difference between her salary of $50,000 and $40, 125. In total, Mary owes the Government $6,790.00 in taxes for the year. (Note: this is an extremely simplified example, just for illustration purposes.)
Dividend income tax system
Now, let’s go back to the dividends. As we said, the nonqualified (ordinary) dividends are taxed at the same as your income tax bracket. Mary from our example would pay 22% taxes on her nonqualified dividends. What would she end up paying if she had qualified dividends?
Since Mary’s total income for the previous year was $50,000 she belongs in the second group owning 15% of her dividend income in taxes. Much better than 22%, don’t you think?
How long do you need to hold dividends?
The ex-dividend date is, simply, the first day that the stock is trading without a dividend payment attached to it. For instance, you are buying a share of Apple on the ex-dividend date – you are not entitled to the next dividend that will be paid out, your seller is. Don’t worry, if you keep it, you will get it the next time!
How do you file?
When you receive more than $10 in dividends from any investment, your brokerage firm will issue a Form 1099-DIV. This document will show not only dividends that you got, but also any capital gains that occurred, and any tax withholdings. But, even if you don’t receive any 1099-DIV form, you are responsible for reporting all the income from dividends. For filing, use Form-040 or 1040-SR to report all your dividends.
My brokerage firm is Robinhood, and the documents are ready to be downloaded in the first week of February for the previous year. I use Turbotax for filing my taxes. Transferring documents from one company to another are very easy. Once the documents are ready, the online software fills the right columns in tax forms for you.
This is too complicated.
Okay, okay, I admit it. This is not a really fun topic unless you are a special kind of a nerd. The purpose of this piece is to be aware of two things:
- If you are receiving dividend payments from any of your investments, you have to pay taxes
- The tax rate will depend on a type of dividends, and your income
The good news is that IRS says: “The payer of the dividend is required to correctly identify each type and amount of dividend for you when reporting them on your Form 1099-DIV for tax purposes”. So, you don’t have to do much, since companies you have investments in together with your brokerage firm will do the job for you.
However, if you have questions about where to park your money to avoid paying to much in taxes, I suggest finding a good financial advisor.