Are Dividends Taxed at a Lower Rate?

By Selena Maranjian Markets Fool.com

Ignore dividends at your own peril. You may think of them as sleepy investments for grandparents, but that's outdated thinking. Dividends are powerful wealth generators. Accordingto Ibbotson Associates, dividends generated about 42% of the 10.04% average annual total return of the S&P 500 Index from January 1926 through December 2016.

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But wait -- it gets better -- because in many cases, dollars from dividends are taxed at a lower rate than other dollars.

Image source: Getty Images.

Let's take a closer look at how your dividends may be taxed.

Qualified vs. unqualified dividends

First, remember that there are a bunch of tax brackets reflecting the percentage of tax that's levied on your income. The brackets apply to much of your taxable income, but long-term capital gains (from qualifying assets held for more than a year) get a more favorable tax rate, as do qualified dividends. You can see the difference in this chart:

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Tax Bracket/Ordinary Dividend Tax Rate

Qualified Dividend Tax Rate

10%

0%

15%

0%

25%

15%

28%

15%

33%

15%

35%

15%

39.6%

20%

Data source: IRS.gov.

To be considered "qualified," the dividends need to have been paid by a U.S. corporation or a qualified foreign corporation, and must be regular dividends -- not distributions of capital gains or dividends from a savings account at a bank or anything like that. You have to have owned the dividend-paying stock for a particular minimum time period, too, explained here by the IRS:

You must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. The ex-dividend date is the first date following the declaration of a dividend on which the buyer of a stock is not entitled to receive the next dividend payment. Instead, the seller will get the dividend.

Got it? It is a bit confusing, but rest assured that most dividends paid to you by most companies you can invest in will be qualified. For most of us, that means an appealingly low 15% tax rate on them. Learn more about the rules from the IRS itself.

Image source: Getty Images.

Dividends inside IRAs

Of course, some dividends come from stocks you hold in an IRA. How do they get taxed? Well, it depends on the kind of IRA it is. If you invest within a Roth IRA and follow the rules (having had the account for at least five years and being at least 59 1/2 years old when withdrawing), when it comes time to withdraw from it in retirement, you'll be able to make tax-free withdrawals. That includes any dividends that various holdings generated. So when it comes to dividends in a Roth IRA, the tax rate is generally 0%.

Traditional IRAs are different, though. Contributions to a traditional IRA are made on a pre-tax basis, so money taken from one does get taxed -- but only when you withdraw it. Until then it grows on a tax-deferred basis. When your withdrawals are taxed, though, it's not at any long-term capital gains tax rate but at your ordinary income tax rate -- reflected in the tax brackets above. That's true no matter whether the withdrawal is made up of capital gains, dividends, and/or interest. This can still be a good deal, as your tax bracket may be 28% when you're working and only 15% when you're retired.

Double taxation of dividends

Finally, it's worth reviewing the common gripe about dividends, that they get taxed twice. Imagine that you own shares of stock inFree Range Onion Company (Ticker: BULBZ). You and the other shareholders actually own the company, which takes in revenue and aims to produce profits. Before the company arrives at your profit, though, it pays its corporate taxes.

After it has paid taxes, Free Range Onion Company may have a profit left over. It can do lots of things with that money, such as paying off debts, reinvesting in its business, buying back some shares, or paying a dividend. If it pays you a dividend, it's doing so with money that has already been taxed -- yet you will probably be taxed on it, too.

Image source: Getty Images.

The power of dividends

No matter how they're taxed, dividend-paying stocks are well worth considering for your portfolio. Not convinced? Consider this: Researchers Eugene Fama and Kenneth French, studying data from 1927 to 2014, foundthat dividend payers outperformed non-payers, averaging 10.4% annual growth vs. 8.5%. The table below shows how a seemingly modest difference in growth rates can make a big difference over the long run to annual investments of $10,000:

Growth Over...

Growing at 8.5% Annually

Growing at 10.4% Annually

10 years

$161,000

$179,400

20 years

$524,900

$661,800

30 years

$1.3 million

$2.0 million

Calculations by author.

For minimum taxation of your dividends, keep them in a Roth IRA. But no matter where you have them, according to current rules, most are likely to face a tax rate of no more than 15%.

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