Like other earnings and realized gains on investments, yes, dividends are indeed taxable. The tax rate on dividends, however, is dependent on a number of factors, including your taxable income, the type of dividend such as qualified or ordinary dividends, and the kind of account you own the investment in. This means that the tax you owe on dividends can vary. 

Let's take a closer look at the various situations that can affect how much you owe in tax on the dividends you earn each year. 

Screenshot with the word dividends and various icons on it.

Image source: Getty Images.

Are dividends taxed?

The short answer to this question is, 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 you own 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 in these accounts is tax-free. 

Another exception is dividends earned by anyone whose taxable income falls in the three lowest U.S. federal income tax brackets. For single filers, that means if your 2020 taxable income is $40,125 or less, or $80,250 or less for married joint filers, you won't owe any income tax on dividends earned. 

There are also some types of dividends that are not taxable events, most commonly a return of capital. In this case, the company is sending you money like a dividend, but it's classified as a return of some of the capital you invested. While not taxable today, this could increase future taxes, since your cost basis is lowered by the amount you got.

Here's an example. If you paid $20 per share, and the company sent you a $0.50 per-share dividend classified as a return of capital, your cost basis is lowered to $19.50. If you sell those shares for a profit in the future, that's an extra $0.50 per share in capital gains you may owe tax on down the road. 

Determining if you have to pay tax on stock dividends 

The answer depends on three things:

  1. What kind of brokerage account was the dividend earned in?
    1. You may owe tax on dividends earned in taxable brokerage accounts, while not owing tax on dividends in retirement accounts like a Roth IRA or 401(k), or college savings accounts like a 529 plan or Coverdell ESA. There are exceptions, including certain pass-through entities like master limited partnerships, which can result in owing tax even in a retirement account.
  2. Was the dividend a qualified dividend, an ordinary dividend, or a nontaxable distribution such as a return of capital? This will determine what -- if any -- the dividend tax rate is.
  3. How much taxable income did you earn? The dividend tax rate you pay -- which could be zero -- is determined in part by your tax bracket, both on qualified and ordinary dividends. 

Here's a summary of when you won't pay tax on dividends:

  • If your taxable earnings are in one of the lowest federal income tax brackets.
  • Dividends earned in a tax-deferred account such as those described above, even if your taxable earnings are in a higher tax bracket.
  • A notaxable dividend such as a return of capital. 

How much tax do you pay on dividends?

Now let's discuss how to figure out how much tax you pay on dividends that are indeed taxable. 

The main distinction in U.S. tax law that determines how dividends are taxed is the definition of qualified and nonqualified dividends. Qualified dividends get taxed at the lower rates stated on the table below, while nonqualified dividends get taxed at the ordinary income tax rate. 

In order for a dividend to be considered qualified, it needs to meet two main criteria.

  1. First, it needs to be paid by a U.S. corporation, a corporation incorporated in a U.S. possession, 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 certain types of companies aren't treated as paying qualified dividends. For instance, real estate investment trusts -- REITs -- and certain other pass-through entities including master limited partnerships typically pay out distributions that are taxed as ordinary income, rather than at preferential qualified dividend rates.
  2. Second, you must have owned the stock that paid the dividend for more than 60 days within a 121-day holding period. The period begins 60 days before the ex-dividend date of the particular dividend in question, and it ends 60 days after the ex-dividend date. This prevents traders from getting tax-favored income on stocks they only hold for a few days.

This table breaks down the tax rate you'll pay, depending on whether the dividend is considered a qualified dividend (on the right) or an ordinary dividend (on the left.)

Ordinary Income Tax Rate

Tax Rate on Qualified Dividends

0%

0%

10%

0%

15%

0%

25%

15%

28%

15%

33%

15%

35%

15%

39.6%

20%

Data source: IRS.

To summarize, here's how dividends are taxed, assuming they are held and earned in a taxable account: 

  • Qualified dividends are taxed at 0% if you're in one of the three lowest income tax brackets, at the 15% capital gains rate for the next four income tax brackets, and at the 20% capital gains rate for earners in the very highest income tax bracket. 
  • Ordinary (unqualified) dividends and taxable distributions are taxed at your marginal income tax rate, based on your taxable earnings. 

Higher earners may owe the Net Investment Income Tax

In addition to the dividend taxes above, dividend investors with modified adjusted gross incomes above $200,000 (single) or $250,000 (married) are also potentially subject to the Net Investment Income Tax, whether those dividends are qualified or unqualified. In this case, an additional 3.8% tax applies on dividend income (as well as realized gains), increasing the effective total tax rate on dividends and other investment income.

Yet even with this surcharge, qualified dividends in particular are still given significant preferential rates versus regular income. That doesn't reduce the risk of stocks, but it does offer the prospect of keeping more of your hard-earned money for yourself.

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