The Tax Trap Every Dividend Investor Should Know About

The tax laws have a lot of strange provisions, and tax reform only highlighted just how complicated the rules governing taxation are. Because of the way that all the different rules interact with each other, there are often some surprising and painful traps hidden within what otherwise seem to be ordinary parts of the tax code.

One particularly difficult situation can arise with middle-income taxpayers who have investment income from dividends. Although certain qualified dividends get preferential tax treatment, there are situations that can effectively cause your marginal tax rate to more than double.

How dividends get taxed

Most dividend income that U.S. taxpayers receive qualifies for favorable tax treatment. Rather than having to pay ordinary income tax rates of up to 37% on qualified dividends, lower tax rates apply. Although tax reform introduced some minor disparities at the fringes, the general rule is that those in the 10% and 12% tax brackets pay 0% tax on their qualified dividends, those in the 22% to the lower part of the 35% brackets pay 15% tax, and those in the upper 35% and 37% brackets pay 20% tax.

In order to be treated as a qualified dividend, a payout has to meet three rules. First, it has to be paid by a U.S. corporation or a foreign company whose shares are listed on a major U.S. stock exchange. Second, the payer has to be subject to taxation at the corporate level, rather than being a pass-through entity that pays no entity-level taxes. Finally, the shareholder has to hold the dividend-paying stock for a certain minimum period of time during the period surrounding the payment -- at least 61 days during the period that starts 60 days before the ex-dividend date and ends 60 days afterward.

When dividend taxes can create a big marginal tax rate hike

Usually, tax breaks are a benefit, but unfortunately, they can have unintended side effects. With respect to dividends, if your income is close to the top end of the where the 0% rate ticks up to the 15% rate, then you run the risk of seeing an unusually large tax increase if your income from other sources goes up slightly.

It's easiest to show how this works with an example. Say that you're single and have taxable income of $38,600, of which $1,000 is qualified dividend income. In that case, you'd pay 0% tax on your dividend income, and you'd pay ordinary tax rates on the remaining $37,600. The math works out to $4,321 in tax, and that number's about 11.5% of your taxable income -- consistent with the expected tax rate structure.

However, say that you get a $100 bonus, taking your taxable income to $38,700. Here, you'd have to pay regular tax rates on $37,700, which would take the tax on regular income up to $4,333. However, because your taxable income ticked above the $38,600 threshold for 0% qualified dividend tax treatment, you'd have to pay a 15% tax rate on $100 of dividend income. That'd add another $15 in tax, taking your total bill up to $4,348. In other words, that extra $100 income would cost you $27 in extra taxes -- working out to a 27% marginal rate on that $100, which is far above the usual tax rates for that income level.

Know what tax impacts are out there

Obviously, if you have a chance to make an extra $100, it doesn't make sense to give it up just to save yourself $27 in extra taxes. It rarely makes sense to make less income deliberately just because of taxes, no matter how high the rates are.

The key here, though, is that there are cases in which tax rates can effectively end up being much higher than they'd seem at first. By being aware of those traps, you can take steps to avoid them when possible and prepare for them when you can't do anything to steer clear of them.

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