This article was originally published on June 11, 2015 and was updated on Mar. 20, 2016 to include 2016 dividend tax rates.
It's been proven that investing for the long haul outperforms short-term trading, and it's been shown that dividend-paying investments perform better than their non-dividend paying counterparts, so building a long-term portfolio that consists of dividend-paying companies can be a great wealth-building strategy.
However, there are some specific tax implications associated with dividend portfolios that investors ought to keep in mind. For example, many Americans will take a hit at tax time because of dividend income, and while that tax burden shouldn't dissuade you from dividend investing, planning for the IRS's cut can help you avoid surprises when you file.
Paying the piper
It shouldn't be too surprising to learn that the IRS considers dividends paid by corporations to investors to be taxable income.
In most cases, your investment advisor or mutual fund will provide you with the amount of dividend income earned in the previous tax year in box 1a of form 1099-DIV, which is sent to investors annually ahead of the April tax deadline.
The amount of tax you'll pay on that dividend income varies depending on the dividend tax rate associated with your overall income and whether or not dividends are qualified or unqualified.
If you're a long-term investor, most dividend income will be qualified as long as the dividend payment is paid by a U.S. corporation or a qualified foreign corporation, and dividends are associated with an investment that has been held for longer than the minimum period of time required.
Types of dividend income that can't be considered qualified can be viewed here, but generally speaking, as long as you've owned a stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date, it will fall into the qualified dividend camp.
In the following table, dividend tax rates for qualified dividends paid in 2015 are broken out by ordinary tax rates for each income range in the column to the far right. You'll notice that you won't have to pay any tax on your dividend income if taxable ordinary income puts you in the lowest two tax brackets. For example, if you're married filing jointly, your dividend income will not be taxed if your ordinary income is less than $74,900.
You will be on the hook to pay a tax, however, if ordinary income puts you in an income tax bracket that is above those two lowest levels. People in the 25% to 35% tax bracket will have to hand over 15% of their dividend income to the IRS, while those in the highest 39.6% tax bracket will need to pay 20%.
This next table shows how inflation adjustments will impact tax rates on dividends paid in 2016.
Retirement plan dividend tax rates
If you own dividend-paying investments in your retirement accounts, you should know a couple more things about dividend tax rates.
First, if you invest in dividend-paying companies in a traditional IRA or a retirement plan, such as a 401(k) plan, dividends aren't taxed at the time they're issued to you. Instead, they are taxed as ordinary income when you begin taking distributions from that IRA or plan. As a result, the tax you pay on dividends earned could end up being greater in these accounts than what would have been paid if they were owned in a taxable account (see the table above).
Second, if you own dividend-paying stocks in a Roth IRA, the dividend payments are not taxed at any point, because Roth IRAs are funded with post-tax dollars; as a result, distributions are generally tax-free if you follow the rules regarding Roth IRA distributions. For that reason, Roth IRAs can be an ideal way to own dividend-paying stocks to benefit from compounding interest on dividend income.
And another thing
For most dividend investors, paying taxes is a cost of doing business, and that means dividend taxes shouldn't keep you from investing in dividend-paying companies. It also means investors may benefit by focusing less on the tax implications of a dividend paying investment and more on the long-term potential health of the investment being considered. For example, a high dividend-yielding investment is often high for a reason, and that can mean high dividend-paying companies carry greater risk.
Regardless, planning ahead to make sure you have enough money available at tax time to cover the IRS bill associated with your dividend income is critical, because it may help you avoid the risk of being forced to sell the underlying investment to cover the tax, and that makes knowing your dividend tax rate important to your long-term investing success.