There are two ways to make money from buying stocks. The first is to sell your shares for a price that's higher than what you originally paid, and the second is to hold your shares and collect dividends.
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Dividend stocks can provide a nice income stream for investors of all ages, but if your portfolio contains dividend stocks, you may be wondering about the tax treatment of your divided income and how much you'll end up paying. In reality, the extent to which you'll pay taxes on dividend income will depend on your tax rate and the type of dividend at hand.
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Types of dividends
Dividends from stocks in a traditional (non-retirement) brokerage account are treated differently from a tax perspective than dividend payments for stocks held in a retirement account. If you hold dividend-paying shares in a Roth IRA, you'll never pay taxes on your dividends. Even with a traditional IRA, you won't pay taxes on your dividends directly but rather will get taxed on distributions from your account once you take withdrawals in retirement.
The type of dividend you receive also makes a difference in terms of the income taxes you'll end up paying. Dividends are generally broken down into two categories: qualified and non-qualified. If you're a typical long-term investor, the majority of your dividends will probably be qualified, and that's a good thing, because qualified dividends get better tax treatment.
To be considered qualified, a dividend must be issued by either a U.S. corporation or a foreign company that trades on a major U.S. exchange. Furthermore, you'll need to have held the shares for more than 60 days within a specific 121-day holding period, which begins 60 days before the ex-dividend date (the first day a stock trades without its dividend included in its share price) and ends 60 days after the ex-dividend date.
Taxes on qualified and non-qualified dividends
The reason it's so important to distinguish between qualified and non-qualified dividends is that the type of payment you receive can affect the amount of tax you're required to pay. The following table shows how much tax you can expect to pay for qualified and non-qualified dividends depending on your typical tax rate:
TABLE BY AUTHOR. DATA SOURCE: INTERNAL REVENUE SERVICE.
You'll notice that the tax rate for qualified dividends is similar to the current tax rate for long-term capital gains. Your takeaway? There's a tax benefit to retaining investments for the long haul.
Reporting dividend income on your taxes
If you receive any sort of dividend income during the year, you'll need to report it on your income taxes. You'll usually receive a 1099 form listing your dividend payments for the year from the financial institution at which you hold your investments, which makes reporting your income easy. Be prepared to pay taxes on your dividend income even if you took those dividends and reinvested them; since that income is still considered yours, the IRS is going to want its share.
If you hold dividend stocks, pay attention to the payments you receive throughout the year. Knowing what to expect can make things a lot less stressful come tax season.
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