The stock market has provided amazing returns for investors in recent years, and those who've invested in dividend stocks have gotten the dual benefit of seeing share prices rise in a booming market, as well as getting regular income payments from their investments. Yet now that interest rates are starting to rise, some income-hungry investors are looking more closely at alternatives, like bonds and bank CDs, to provide the cash flow they need without the stock market risk that they've dealt with over the years.

Before you make a major shift in your investment strategy, though, it's important to understand the tax consequences of holding various types of investments. Specifically, many dividend stocks qualify for preferential tax rates on the income they pay out that bonds and bank CDs never get. If you're investing in a taxable account, it's vital to know whether you can cut your taxes by staying committed to high-quality dividend stocks.

Blue field with word Dividends and several symbols representing stock market sectors.

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What do I have to do to get a low tax rate on my dividends?

Only some dividend stocks qualify for the lower tax rates under the current tax law. If your dividend stock doesn't qualify, you'll end up paying the same tax rates that apply to other types of income, including both wages and salaries and other forms of investment income, like bond and CD interest payments.

Qualified dividends have to meet certain guidelines, two of which apply to the company paying the dividend. The other has to do with your ownership of the stock.

The company paying a qualified dividend must be a U.S. corporation that's incorporated in a U.S. possession or a foreign corporation whose shares are listed on a major stock exchange within the U.S., such as the New York Stock Exchange or the Nasdaq Stock Market. Also, investment entities that don't pay corporate-level taxes and instead pass through their taxable income directly to shareholders -- such as real estate investment trusts, business development companies, and regulated investment companies -- only pay qualified dividends to the extent that the income those entities receive is itself qualified dividend income.

For a dividend to be qualified, you need to meet an ownership test that requires a minimum holding period. Specifically, when you look at each dividend payment, you need to have owned the stock for more than half of a roughly four-month period surrounding the date on which you become entitled to receive the dividend. Technically, the rule requires ownership for 61 days out of the 121-day period that starts 60 days before the ex-dividend date for the stock and ends 60 days afterward.

What's the big deal about qualified dividends?

The reason qualified dividends are better than non-qualified dividends is that you pay a lower tax rate on them. For some taxpayers, qualified dividend income is tax-free, and the tax rate is always less than what you'd pay for ordinary income.

Under the law in 2017 and earlier, the way qualified dividend taxes worked was simple: If you were in the 10% or 15% tax brackets for your ordinary income, you paid 0% tax on qualified dividends. Those in higher brackets generally paid 15% in dividend tax, while top-income taxpayers in the 39.6% bracket paid a 20% tax rate on qualified dividends.

Now things are more complicated, because the tax reform law that changed the regular tax brackets for 2018 and beyond didn't match up the dividend tax rates accordingly. You can find the exact bracket amounts here, but in general, those in the 10% and 12% brackets typically will pay no tax on qualified dividends; those in the 22% to the 35% brackets will pay 15%; and those in the top-most part of the 35% bracket or the 37% bracket will pay 20%.

Think twice before you switch

The tax advantage of dividend stocks can make a substantial difference in the after-tax income you receive from your investments. For instance, interest rates on 10-year Treasury bonds have climbed toward 3%, which might make them look more attractive than a dividend stock yielding 2.5%. But if you're in the 35% bracket for regular income and 15% for qualified dividends, the after-tax income yield amounts to 1.95% on the bond versus 2.12% for the dividend stock.

Lower tax rates are a big draw of dividend stocks, especially for people who rely on the income they provide to make ends meet. Even as rates on alternatives improve, you'll still want to keep dividend stocks as a key part of your income-producing portfolio.

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