Like other earnings and realized gains on investments, dividend income is indeed taxable. The tax rate on dividends, however, is dependent on a number of factors, including your taxable income, the type of dividend, and the kind of account that holds the investment. This means that the amount of the tax that you owe on dividends can vary.
Let's take a closer look at the various factors that can affect how much you owe in tax on the dividends you earn each year.
Are dividends taxed?
The short answer to this question is that yes, in most cases, dividends are taxed. A more complete answer is yes, but not always, and it depends on a few circumstances. Let's look at some exceptions.
A common exception is dividends paid on stocks held in a retirement account such as a Roth IRA, traditional IRA, or 401(k). These dividends are not taxed since any income or realized capital gains earned by these types of accounts is always tax-free.
Another exception is dividends earned by anyone whose taxable income falls into the three lowest U.S. federal income tax brackets. For single filers, if your 2020 taxable income is $40,000 or less, or $80,000 or less for married couples filing jointly, then you won't owe any income tax on dividends earned. Those numbers bump up to $40,400 and $80,800, respectively, for 2021.
There are also some types of events that pay dividend-like income that is not taxable; the most common event is a return of capital. In this case, the company is sending you money much like a dividend, but it's classified as a return of some of the capital that you invested. While not taxable today, receiving this type of dividend could increase your future taxes since your capital gain on the stock is increased by the amount of the dividend that you received.
Here's a specific example. If you pay $20 for a single share and the company sends you a $0.50 dividend classified as a return of capital, then your cost basis decreases to $19.50. If you sell the share in the future for a profit, then that's an extra $0.50 in capital gains on which you would owe taxes.
How to determine if you owe tax on stock dividends
Whether you owe taxes on a dividend depends on three factors:
- Type of investment account: You may owe tax on dividends earned by stock held in a taxable brokerage account. You would not owe tax on dividends from stocks held in a retirement account like a Roth IRA or 401(k), or a college savings plan like a 529 plan or Coverdell ESA. There are exceptions to this tax immunity, though. Certain pass-through entities such as master limited partnerships can create tax obligations even for retirement accounts.
- Type of dividend: The tax rate, if any, depends in part on whether the dividend is a qualified dividend, which means it is eligible for a lower tax rate; an ordinary or non-qualified dividend, meaning it is taxed at the investor's ordinary income tax rate; or a nontaxable distribution, such as a return of capital.
- Your taxable income: Your tax bracket partly determines the tax rate applied to any dividends you earn, whether qualified or ordinary.
Here's a summary of when you won't pay tax on dividends:
- If your taxable earnings are in one of the three lowest federal income tax brackets and you receive qualified dividends.
- If the dividends are earned in a tax-deferred account such as one of those described above, even if your tax bracket is not one of the three lowest.
- If the dividend was a nontaxable dividend such as a return of capital.
How much tax do you owe on dividends?
Now let's examine how much tax is assessed on dividends that are indeed taxable.
Dividends are taxed differently based on whether they are considered qualified or ordinary dividends under U.S. tax law. For a dividend to be considered qualified, it must meet two main criteria:
- The dividend needs to be paid by a U.S. corporation domiciled in a U.S. state or territory or a foreign corporation listed on a major U.S. stock exchange. That might sound like it includes most stocks, but keep in mind that the payouts from certain types of investments aren't treated as qualified dividends. Real estate investment trusts (REITs) and certain other pass-through entities, including master limited partnerships, pay out distributions that are taxed typically as ordinary income rather than at the preferential rates reserved for qualified dividends.
- You must have owned the stock paying the dividend for more than 60 days within a specific 121-day holding period. The 121-day period begins 60 days before the ex-dividend date of the stock, which is exactly 60 days before the next dividend is distributed. This mandatory holding period prevents traders from earning tax-advantaged income on stocks that they hold for only a few days.
Qualified dividends get taxed at favorable rates, while non-qualified or ordinary dividends are taxed at your ordinary income tax rate. The following four tables break down the current tax rates assessed on qualified dividends, depending on your taxable income and filing status in 2020 and 2021:
|2020 Qualified Dividend Tax Rate||For Single Taxpayers||For Married Couples Filing Jointly||For Heads of Households|
|0%||Up to $40,000||Up to $80,000||Up to $56,600|
|15%||$40,001 to $441,450||$80,001 to $496,000||$53,601 to $469,050|
|20%||$441,451 or more||$496,601 or more||$469,051 or more|
|2021 Qualified Dividend Tax Rate||For Single Taxpayers||For Married Couples Filing Jointly||For Heads of Households|
|0%||Up to $40,400||Up to $80,800||Up to $54,100|
|15%||$40,401 to $445,850||$80,801 to $501,600||$54,101 to $473,750|
|20%||$445,851 or more||$501,601 or more||$473,751 or more|
These next two tables present the tax rates assessed on ordinary or non-qualified dividends in 2020 and 2021, depending on your taxable income and filing status:
|2020 Ordinary Dividend Tax Rate||For Single Taxpayers||For Married Couples Filing Jointly||For Heads of Households|
|10%||Up to $9,875||Up to $19,750||Up to $14,100|
|12%||$9,876 to $40,125||$19,751 to $80,250||$14,101 to $53,700|
|22%||$40,126 to $85,525||$80,251 to $171,050||$53,701 to $85,500|
|24%||$85,526 to $163,300||$171,051 to $326,600||$85,501 to $163,300|
|32%||$163,301 to $207,350||$326,601 to $414,700||$163,301 to $207,350|
|35%||$207,351 to $518,400||$414,701 to $622,050||$207,351 to $518,400|
|37%||$518,401 or more||$622,051 or more||$518,401 or more|
|2021 Ordinary Dividend Tax Rate||For Single Taxpayers||For Married Couples Filing Jointly||For Heads of Households|
|10%||Up to $9,950||Up to $19,900||Up to $14,200|
|12%||$9,951 to $40,525||$19,901 to $81,050||$14,201 to $54,200|
|22%||$40,526 to $86,375||$81,051 to $172,750||$54,201 to $86,350|
|24%||$86,376 to $164,925||$172,751 to $329,850||$86,351 to $164,900|
|32%||$164,926 to $209,425||$329,851 to $418,850||$164,901 to $209,400|
|35%||$209,426 to $523,600||$418,851 to $628,300||$209,401 to $523,600|
|37%||$523,601 or more||$628,301 or more||$523,601 or more|
To summarize, here's how dividends are taxed, provided that the underlying stocks are held in a taxable account:
- Qualified dividends are taxed at 0%, 15%, or 20%, depending on your income level and tax filing status.
- Ordinary (non-qualified) dividends and taxable distributions are taxed at your marginal income tax rate, which is determined by your taxable earnings.
High earners may owe the Net Investment Income Tax
In addition to potentially paying the dividend taxes described above, dividend investors with modified adjusted gross incomes above $200,000 (for single taxpayers) or $250,000 (for married couples filing jointly) are also potentially subject to paying the Net Investment Income Tax. This tax is assessed regardless of whether the dividends received are classified as qualified or ordinary. The Net Investment Income Tax is an additional 3.8% tax that applies to dividend income (as well as realized gains) and increases the effective total tax rate on dividends and other investment income.
Yet, even with this surcharge, qualified dividends in particular are taxed at significantly preferential rates versus regular income. That doesn't reduce the risk of investing in the underlying stock, but it does offer the prospect of keeping more of your hard-earned gains for yourself.