Are Dividends Taxed at a Lower Rate?

How your dividends are qualified will play a big role in how they are taxed. Image source: Chris Potter, via Flickr.

Dividends are the cornerstone of long-term success for the vast majority of individual investors. The compounding effect of receiving dividends every quarter -- and reinvesting them in shares of the company or fund that you own -- is massive, if you give it enough time.

As the end of tax season is upon us, many investors are wondering: Are dividends taxed at a lower rate? The answer: It depends.

In the end, the dividends you get in your account can be qualified in three different ways. Those qualifications will play a huge role in how much you'll owe in taxes.

Here's how you can visualize those three different types of dividends.

Image source: Author.

Dividends in your retirement account
No matter what type of retirement account you have, you usually will not pay taxes on the dividends you receive -- at least not directly.

Basically speaking, there are two types of retirement accounts. The first is a Roth IRA or Roth 401(k). In these accounts, you pay taxes on your contributions when you put the money in. After that, you're home free. So if you own shares of a stock or mutual fund that pays dividends in your Roth, you'll never pay a dime for any growth you experience thanks to those dividends.

The other type of retirement account allows you to deduct the money that you contribute immediately, and you pay taxes later. The most common forms of such accounts are regular 401(k)s, Traditional IRAs, and a host of other less common retirement accounts.

But even here, you don't pay taxes on your dividends directly. You only get taxed on distributions you get from your retirement account during your retirement years. Of course, a part of these distributions is likely thanks to the dividends that you've accumulated over the years. But technically speaking, it's just the cash you pull out -- and not the dividends themselves -- that is taxed.

Qualified vs. non-qualified dividends
There are lots of individual investors that hold shares of dividend-paying stocks or funds outside of their retirement accounts. For these folks, the difference between "qualified" and "non-qualified" dividends is important.

The short explanation is that if you're a long-term shareholder, almost all of your dividends will be qualified.

The longer explanation goes like this: You must own shares of the dividend-paying entity for over 60 days during a 121-day period that begins 60 days before the ex-dividend date -- or the date after a company's board declares a dividend.

Sound confusing? Here's an easier way to think about it: There's a window spanning 60 days before a company declares a dividend to 60 days after. You need to own the stock in question for over half of these days.

What are the benefits to this?
No matter your tax bracket, you'll always be rewarded for buying and holding a dividend-paying stock. For 2016, here's the amount of tax you owe on dividends, depending on your marginal tax bracket.

Data source: IRS.

As you can see, the savings you'll get by holding your dividend stocks for the long run can be massive. A person in the 35% tax bracket who receives $10,000 per year in dividends will save $2,000 if all of her dividends are qualified as opposed to non-qualified. Added up over a lifetime of investing, that can make a big difference.