Tax Treatment of Dividend Income
- Dividend-paying investments may help meet your portfolio needs.
- Dividend income and its tax implications are important to you as an investor.
Taxes on dividends: ‘qualified’ vs. ‘nonqualified’
Investors tend to find some dividend-paying stocks and mutual funds attractive because their total return includes both the dividend and any market price appreciation. Considering taxes and dividend income, seasoned investors have learned the special qualified dividend treatment may increase their after-tax return when compared to nonqualified dividends.
For those investors whose income exceeds certain thresholds, they will need to keep an eye on the additional 3.8% Medicare surcharge. Under current legislation, single taxpayers with a Modified Adjusted Gross Income (MAGI) of $200,000 and married couples with an MAGI in excess of $250,000 are subject to an additional 3.8% Medicare surcharge on net investment income (which includes all taxable dividends).
For tax purposes, it’s important to know dividends are considered either “qualified” or “nonqualified.” Qualified dividends are taxed using long-term capital gain rates of 0%, 15%, or 20% depending on your level of taxable income:
Nonqualified dividends are taxed at the same rates as ordinary income (currently a 37% maximum).
What’s a ‘qualified’ dividend?
Qualified dividends are paid to investors in common and preferred stock of U.S. corporations or by entities incorporated in a U.S. possession. Dividends passed through by mutual funds or other regulated investment companies can be qualified or nonqualified, depending on the underlying securities held by the fund.
If a fund receives a qualified dividend, the dividend will maintain its qualified status when passed through to shareholders. Distributions from partnerships and real estate investment trusts typically are not characterized as qualified dividends. Also, qualified dividends do not include distributions from preferred debt.
Dividends paid by certain foreign corporations may also be qualified. Examples include:
- Shares represented by a publicly traded American Depositary Receipt (ADR)
- Shares that are otherwise readily tradable on an established U.S. securities market
- Corporations incorporated in a U.S. possession
- Corporations incorporated in a country having an income-tax treaty with the United States containing an exchange of information program approved by the U.S. Treasury
Keep in mind that the foreign corporate dividend may remain subject to foreign tax withholding.
It’s critical to obtain proper tax classification of an investment to determine whether the dividend is qualified.
How does the qualified dividend tax treatment work?
For example, Jake has $68,000 in 2018 taxable income, excluding qualified dividends of $10,000. His $10,000 in qualified dividends pushes his total taxable income above $77,200, the threshold of the 0% long-term capital gain rate for married filing jointly. As a result, $9,200 of Jake’s qualified dividends would be tax-free, while the remaining $800 [$78,000 (his total income) – $77,200] would be taxed at 15%.1
Is there a required holding period?
To qualify for the special tax treatment, shareholders must satisfy a certain holding period2 based on the type of stock held:
There are tax advantages to owning a qualified-dividend-paying stock – but that alone doesn’t make the stock appropriate for your portfolio.
- For common stock, shareholders must own the stock for more than a 60-day period containing the ex-dividend date.
- For preferred stock, the owner must hold the shares for more than a 90-day period including the ex-dividend date.
Active traders should monitor their holding periods carefully to benefit from the qualified-dividend tax treatment.
Capital losses and offsetting qualified dividends
Although dividends and long-term capital gains are taxed at the same rates, this does not mean capital losses can be used to offset dividends. However, if you have a net capital loss after offsetting all capital gains, up to $3,000 per year of capital loss may offset regular taxable income, which may include dividends.
Get the right advice
It’s important to understand how dividends are taxed – this is only a brief summary. For more detailed information, contact your tax advisor. Keep in mind taxes certainly affect investment returns. The effects of taxes should be only one of many factors you consider when making investment decisions.
There are tax advantages to owning a qualified-dividend-paying stock — but that alone doesn’t make the stock appropriate for your portfolio. Before you make an investment, your Financial Advisor will work with you to consider a variety of additional factors, such as your long-term goals, time horizon, and risk tolerance.
- Consider if dividend-paying stocks and mutual funds are appropriate investments for your portfolio.
- Look at the whole picture before you invest, including your goals regarding return, risk, time horizon, and taxes.
- Determine if your income threshold is impacted by the 3.8% Medicare surcharge.
- Talk with your Financial Advisor to determine if dividend-paying investments are right for your financial situation.
1 Although this example is conceptually accurate, the actual tax calculation Jake would perform on his tax forms would involve a separate worksheet to determine the amount of the qualified dividends that would be categorized and taxed at various rates.
2 When a stock trades ex-dividend, the dividend, when paid, goes to the seller. In general, the exchange designates a stock as ex-dividend a few days before the record date. Certain hedge positions may suspend the holding period for this purpose.