Dividends aren’t free money — they’re usually taxable income. But how and when you own an investment that pays them can dramatically change the tax bill those dividends rack up.
There are many exceptions and unusual scenarios with special rules — see IRS Publication 550 for the details — but here’s generally how dividend taxes work.
Qualified vs. unqualified dividends
A dividend is a share of a company’s profits that is distributed to shareholders. For tax purposes, there are two kinds of dividends: qualified and nonqualified. Nonqualified dividends are sometimes called ordinary dividends.
For a dividend to be qualified, it first must be paid by a U.S. corporation or qualifying foreign entity. For many investors — be they in stocks, mutual funds or ETFs — this one’s easy to satisfy.
Second, it must actually be a dividend in the eyes of the IRS. Some things don’t count as dividends, despite what they might be called, including:
- Premiums an insurance company kicks back
- Annual distributions credit unions make to members
- “Dividends” from co-ops or tax-exempt organizations
Third and finally, dividends usually count as qualified only if you held the underlying security for long enough. The definition of “enough” gets a little tricky, but typically, if you owned the security for more than 60 days during the 121-day period that began 60 days before the ex-dividend date — that is, the day by when you must own the stock to receive the dividend — the dividend is qualified. (Preferred stock has special rules, by the way.)
Here’s an example. If your Ford shares paid a dividend on Sept. 1 and the ex-dividend date was July 20, you would need to have owned your shares for at least 61 days between May 21 and Sept. 19. And when you count the days, include the day you sold the shares but not the day you bought them.
If you don’t hold the shares long enough, the IRS might deem them nonqualified, and you’ll pay tax at the higher, nonqualified rate.
Dividend tax rates for 2017
The tax rate on qualified dividends usually is lower than the one on nonqualified dividends: It’s 0%, 15% or 20%, depending on your tax bracket. The tax rate on nonqualified dividends the same as your regular income tax bracket. (What tax bracket am I in?)
In both cases, people in higher tax brackets pay more tax on their dividends.
|If you're in this tax bracket ...||... you pay this rate on qualified dividends ...||... but you pay this rate on nonqualified dividends.|
How to pay dividend taxes
After the end of the year, you’ll receive a Form 1099-DIV — or sometimes a Schedule K-1 — from your broker or any entity that sent you at least $10 in dividends and other distributions. The 1099-DIV indicates what you were paid and whether the dividends were qualified or nonqualified. You use this information to fill out your tax return. You might also need to fill out a Schedule B if you received more than $1,500 in dividends for the year.
Even if you didn’t receive a dividend in cash — let’s say you automatically reinvested yours to buy more shares of the underlying stock, such as in a dividend reinvestment plan (DRIP) — you still need to report it. You also need to report dividends from investments you sold during the year.
How to control your dividend tax bill
Pros say a few maneuvers can help.
Watch the calendar
You could save money on taxes by holding your investments for the 61-day minimum, says Terry Deever, a certified public accountant and certified financial planner in Camarillo, California. Just be sure that doing so aligns with your other investment objectives.
Set cash aside
Your employer withholds taxes from your paycheck and sends them to the IRS on your behalf — but there’s usually nobody doing the same with your dividends.
“If they’re significant enough and there’s no other sources of withholding, then estimated taxes are going to have to be paid, and those are paid on a quarterly basis. The tax preparer can assist in determining how much that is, but it is something to take into consideration if you’re receiving large dividends,” Deever warns.
Keep dividend-paying investments in a retirement account
That could shelter dividends from taxes or defer taxes on them, says Ken Corlett, a certified financial planner at WorthPointe in San Diego.
“If you’re generating so much income that you’re affecting your tax bracket, that’s when you want to maybe do some planning,” he says.
Think ahead, though. Do you need the income now? Also, the type of retirement account matters. When you eventually withdraw money from a traditional IRA, for example, it may be taxed at your ordinary income tax rate rather than at those lower qualified dividend rates. If you qualify for a Roth IRA, you won’t receive a tax break on the contribution, but your eventual withdrawals — after age 59 ½ — may be tax-free. This is just one of many things you should consider when deciding between a traditional or Roth IRA. (Not sure what the difference is between Roth and Traditional IRAs? We explain here.)