Why qualified dividends can be advantageous
The biggest advantage of qualified dividends is that they qualify for the lower long-term capital gains tax rate.
As previously noted, the difference in the tax burden can be substantial. For example, let's say you're in the 28% income tax bracket, and you received $2,000 in dividends this year. If these dividends were qualified dividends, you'd pay taxes at a rate of 15%, which would come to $300. However, if these were nonqualified ordinary dividends, you'd pay taxes on them at a 28% rate -- producing a tax bill of $560. In short, owning stocks that pay qualified dividends could cut your taxes on those dividends almost in half.
We see a similar impact for those in lower tax brackets. For example, if you made less than $40,400 in 2021 (or $80,800 for those married and filing jointly), you wouldn't have to pay any taxes on qualified dividend income. However, you'd have to pay a 10% to 12% tax on nonqualified dividends. So, if you received $2,000 in dividends in 2021, you wouldn't pay any tax if they were qualified dividends. However, you'd pay $200 to $240, depending on your income level, if they were nonqualified dividends.
Taking advantage of the rules to do what already works best
Earning dividend income is an excellent way to build long-term wealth. It rewards the patient investor who's willing and able to buy stocks in great companies and to keep holding them while getting paid as those businesses get bigger and stronger. Simply put, buying great businesses and then sitting on your hands works great for dividend investing.
Smart tax planning should play a big role in how you optimize your results. That includes taking advantage of tax-deferred accounts, such as an IRA, or tax-free accounts, such as a Roth IRA, that can help you avoid almost all taxes, even on most dividend income.
But when you're investing in a taxable account, the tax man cometh every year. So, focusing your dividend stock portfolio toward stocks that pay a qualified dividend can make a big difference in how much wealth you can build -- and retain -- before you're ready to start enjoying the fruits of your investing labors.
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