3 Tax Implications of Dividend Stocks

Fact checked by Suzanne KvilhaugReviewed by Khadija KhartitFact checked by Suzanne KvilhaugReviewed by Khadija Khartit

Two things are guaranteed in life: death and taxes. While you can’t control death, you can control how much you pay in taxes. That’s particularly true for dividend investors. After all, if you don’t manage your tax exposure, the income you get from your dividend-paying stocks could eat away at your investment gains.

While no one can avoid paying taxes altogether, there are some tax implications dividend stock investors have to pay attention to. From housing the investments in the wrong account to not taking advantage of tax-loss harvesting, here’s a look at some of the tax impacts of dividend investing.

Key Takeaways

• Owning dividend stocks can generate income for investors and comes with tax considerations.
• Regular dividends are taxed as ordinary income, just like interest or work income, even if they are reinvested.
• Qualified dividends are taxed at the more favorable capital gains rate.
• Keeping dividend flows in tax-exempt accounts shields investors from these taxable events.

Keep the Investments in Tax-Advantaged Accounts

Dividend stocks pay some cash, which is very attractive to income-seeking investors in a low-interest rate environment. Traditional income investments like bonds may not see many gains in certain environments, which is why investors choose dividends. But, gains are taxable if these stocks aren’t held in a tax-advantaged investment account like a 401 (K) or an IRA. That could be a big deal, particularly for investors in a high tax bracket.

There are two tax treatments for dividends. The income is either taxed as a qualified dividend or an ordinary one:

• A qualified dividend is more attractive because it’s taxed at a lower rate. A qualified dividend has to be issued by a company that trades on a major U.S. exchange and you have to own the shares for more than 60 days of the holding period. If you are in the 35% tax bracket, a qualified dividend is going to be taxed at 15%.
• An ordinary dividend is treated as ordinary income, which means the tax hit is the same as any other income. So if you were in the 35% tax bracket, you would face a 35% tax hit.

In either case, a better strategy is to keep the dividend-paying investments out of taxable accounts and hold them in retirement accounts to avoid a big tax event.

Important

You can figure out how much a company pays in dividends relative to its stock price. To calculate the dividend yield, divide the dividend per share by the market value per share.

Reinvested Dividends Can Create a Taxable Event

Some of the companies that offer investors dividends also let them automatically use dividends to purchase more shares of the stock instead of receiving cash payments. Called dividend reinvestments, investors whose dividends are reinvested into more shares of the stock are on the hook to pay taxes on that income as if it were paid in cash without the reinvestment.

There can be a benefit if the dividend is received directly in the form of shares of a stock. That’s because stock dividends aren’t usually taxable until the stock is sold. If there is a choice between cash or stock, then the investor faces a tax event even when choosing stock dividends.

Capital Gains Can Hurt Your Returns

The whole idea behind investing is to make money, and dividend stocks can do that for you. But they can also create a capital gains tax event, which will reduce your gains. That is why tax-loss harvesting can be an important tax strategy. With tax-loss harvesting, you sell an existing holding for a loss to offset the gains generated from the sale of a winning holding.

Source: Internal Revenue Service

There are some rules investors need to be mindful of. For instance, they can’t sell and purchase the same stock again within 30 days of selling it because it’s considered a wash. While many people engage in tax-loss harvesting at the end of the year, it’s something that can be done periodically throughout the year.

What Are the Benefits of Dividend Reinvestment Plans (DRIPs)?

A dividend reinvestment plan (DRIP) allows investors to use the dividends they earn to reinvest them for additional shares in the company rather than cash. Offered by public companies, brokerages, and investment companies, they allow investors to purchase additional shares without any additional cost, including fees. DRIPs give investors a bigger stake in the dividend-paying company and allow them to purchase more shares as time goes on. These companies also benefit because it increases the amount of capital on hand, allowing them to further their growth plans.

How Are Dividends Taxed?

This depends on the type of dividend. Ordinary dividends are taxed as normal income. Qualified dividends are taxed more favorably based on the capital gains tax rate. These rates are 0%, 15%, and 20%. The rate that applies is based on your tax filing status and your income at the end of the tax year.

What Are the Benefits of Owning Dividend Stocks?

Investing in dividend stocks comes with different benefits. These stocks tend to be from companies that have strong growth and low volatility. Dividends provide investors with a passive source of income if they are taken in cash. If they are reinvested, investors can take advantage of compounding, which helps their portfolios grow faster. Dividends paid by certain corporations are considered qualified, which come with better tax treatment.

The Bottom Line

Investors shouldn’t make decisions based on taxes alone, but they should be mindful of the potential tax event from their decisions, particularly when it comes to dividends. To ensure your tax hit isn’t eating away at your gains, investors should invest in qualified dividends, keep income investments in tax-advantaged investment accounts and engage in tax-loss harvesting to offset winners with losers.

Read the original article on Investopedia.