Stock investors make money in two ways. Ideally, the share price of the stocks they own goes up, giving them a profit when they sell. Some stocks also pay dividends to shareholders at regular intervals, giving them income that they can either reinvest in the stock or use for other purposes.
Depending on the type of account that holds your dividend-paying stocks, you might pay taxes on your dividend income. Below, we'll go into the details on how that income gets taxed and some of the preferential tax treatment that's often available for dividends.
The general rule for dividend taxation
In general, dividends are treated as income for tax purposes. Unless you hold your dividend-paying stocks in a tax-deferred account like an IRA or 401(k), you'll have to include your dividends as gross income in the year of receipt.
Many dividends get taxed at lower rates than other types of income. The rules governing which dividends qualify for favorable tax treatment are given below. Dividends that don't meet these qualifications get taxed at the same rates as ordinary income.
Which dividends qualify for lower tax rates?
In order for dividend payments to be considered qualified dividends, you have to pass these tests:
- The dividends must have been paid by either a U.S. corporation or a qualified foreign corporation. This typically requires that a foreign company either be covered under a tax treaty with the U.S. or that its stock be listed on a U.S. stock market, such as the New York Stock Exchange or Nasdaq Stock Market.
- The dividends must not fall into certain excluded categories, including dividends from mutual banks, tax-exempt organizations, or shares held in employee stock ownership plans.
- You must have owned the stock for at least 61 days in the 121-day period that starts 60 days before the stock trades ex-dividend. A longer holding period applies for preferred stock dividends that cover a period of longer than a year.
If you fail any one of these tests, then the dividend is not qualified, and ordinary income tax rates apply.
What are the lower tax rates on qualified dividends in 2021?
Qualified dividends get taxed at lower rates. The exact rate depends on your tax filing status and how much taxable income you have:
Dividend Tax Rate
Married Filing Jointly
Head of Household
Married Filing Separately
$0 to $40,400
$0 to $80,800
$0 to $54,100
$0 to $40,400
$40,401 to $445,850
$80,801 to $501,600
$54,101 to $473,750
$40,401 to $250,800
These numbers are adjusted for inflation every year. Therefore, the income thresholds for 2020 were slightly lower, as you can see here.
In practical terms, these tax rates correspond fairly closely (but not exactly) to the tax brackets for ordinary income. Specifically:
- The 0% tax rate applies to all of the income in the 10% and 12% brackets.
- The 15% tax rate applies to just about all of the income covered in the 22%, 24%, 32%, and 35% tax brackets.
- The 20% tax rate applies to a small portion of income at the top end of the 35% tax bracket and to the 37% bracket.
An extra tax on dividends for high-income taxpayers
In addition to these taxes, a net investment income surtax of 3.8% gets charged on dividend income of high-income taxpayers. The thresholds for this surtax are $200,000 for single and head of household filers, $250,000 for married people filing jointly, and $125,000 for married people filing separately.
Be smart with your dividends
If you want to pay as little tax as possible on dividend income, consider the following strategies:
- Hold dividend stocks in tax-deferred accounts, like traditional IRAs or similar retirement accounts. You won't pay taxes on dividend income as it comes in. Instead, you'll pay only when you withdraw money from the account.
- Invest in stocks whose dividends will qualify for lower rates. Checking foreign companies to make sure they meet the tests is especially crucial.
- Hold onto your stocks for the required holding period. Short-term trading can turn what would be a qualified dividend into a nonqualified one, boosting your tax bill.
Dividend stocks are great ways to build wealth and provide much-needed income. By knowing these rules, you'll be able to do tax planning that ensures you pay as little to the IRS as possible.
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