Only 1 in 6 Taxpayers Use This Tax Break. Here's Why You Should

By Dan Caplinger Markets Fool.com

No one likes to pay more in taxes than they have to, and most taxpayers look for ways to cut their tax bills each April. Yet only one in every six taxpayers takes advantage of a simple way of earning income at a favorable tax rate. By investing in individual stocks and stock funds that pay qualified dividends, you can benefit from the low taxes that the federal government charges on this type of investment income and join the 25 million taxpayers who earn tax savings this way.

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How big a tax break can you get from qualified dividends?

Until the early 2000s, dividends got taxed in the same way as interest and other types of investment income, with taxpayers paying their ordinary income tax rate on both interest and dividends in the same way they would most of their other income. But favorable new tax laws provided for reductions from the nearly 40% tax rate imposed on the highest-income taxpayers and their investment income.

Image source: Getty Images.

Under current law, the tax rate for qualified dividends depends on what your ordinary income tax rate is. In general, though, taxpayers get a 10 to 20 percentage point reduction in what they pay on dividend income.

If your ordinary income tax rate is this:

Then your qualified dividend tax rate is this:

10% or 15%

0%

25%, 28%, 33%, or 35%

15%

39.6%

20%

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Data source: IRS.

These lower rates make it worth it to pursue qualified dividend income.

How much can you save with lower tax rates on qualified dividends?

Indeed, when you look at actual tax return data, you can see that those who take advantage of lower tax rates on qualified dividends produce substantial savings. Out of 25.7 million tax returns that reported qualified dividend income, the average amount claimed was $7,488 per return.

The data doesn't show which tax bracket all of those investors were in, but the implied savings amounts to as much as $1,500 per return. Even for those who get less savings compared to their ordinary income tax rate, savings of roughly $750 would still be attractive.

What makes a dividend qualified?

Not all dividends get favorable treatment. There are two general requirements to earn qualified dividend income. First, the payment must come from a U.S. corporation or from a foreign corporation that has its stock listed on a major U.S. stock exchange. Second, there's a minimum holding period of 61 days, and you must hold the stock at least that long during the period that starts two months before the dividend payment date and ends two months afterward.

Moreover, certain types of investments don't pay qualified dividends even if they'd otherwise meet the requirements above. Typically, entities that pass through their tax characteristics to their investors, such as real estate investment trusts, don't gain favorable tax treatment for all of their distributions to shareholders. Similarly, just because an entity calls something a dividend doesn't mean that it necessarily qualifies. For instance, credit unions often refer to interest payments as being "share dividends," but they still get taxed as regular interest rather than qualified dividends.

Why qualified dividends are a smart move

Yet the best reason to seek out more qualified dividend income has nothing to do with taxes. Investing in stocks is already a good idea for Americans who are looking to reach their financial goals, yet the vast majority of taxpayers avoid stock market investing in their personal finances. The stocks that pay qualified dividend income often produce impressive long-term growth for their shareholders as well, and the capacity for bringing wealth to ordinary American investors is the biggest incentive toward putting together an investment portfolio that includes dividend stocks.

Dividend investing has gotten more popular recently, but a surprisingly large number of people still haven't taken advantage of the growth and income potential that dividend stocks offer. By being aware of the qualified dividend tax break, you'll see even bigger benefits from investing in your future.

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