If you're padding your returns by owning stock in dividend paying companies, you could be positioning your portfolio for great performance. Over time, investing in dividend-paying stocks has produced greater returns than investing in their non-dividend-paying peers.
However, dividend stock investing isn't without its drawbacks. If you receive income in the form of dividends, you could end up with a bigger-than-expected bill at tax time. To avoid such an unwelcome surprise, it pays to plan ahead. So, with that in mind, here are the IRS' dividend tax rates for 2017.
Uncle Sam's share
The IRS considers dividend payments to be taxable income, and therefore taxpayers must include any dividend income on their tax return. How much you'll pay in tax on that income will depend on your overall income and whether or not the dividends are qualified or unqualified.
Typically, the amount of dividend income you receive annually is provided to you by your investment advisor on form 1099-DIV. These forms are are sent out to investors prior to the April tax-filing deadline.
Long-term investors will usually find that their dividend income is qualified if it's been paid by a U.S. corporation or a qualified foreign corporation. The various types of dividend income that can't be considered qualified are listed here, but usually, as long as you've owned a stock for over 60 days during the 121-day period that begins 60 days before the stock's ex-dividend date, it will be considered qualified.
Once you've determined whether your dividend income is qualified, you'll need to do some guesswork regarding what your ordinary income will be this year. As a refresher, ordinary income is income that you receive that isn't capital gains -- like wages or rental income, for instance.
If your level of taxable ordinary income places you in the bottom two income tax brackets, then you won't need to pay income taxes on your dividend income. However, if your ordinary income places you in a higher income bracket, then you'll have to pay between 15% and 20% in income tax on your dividend income.
Dividend tax saving strategies
One of the best ways to reduce the impact of income taxes on dividend payments is to own dividend-paying stocks in tax-advantaged retirement plans, such as 401(k) plans and IRAs. Dividends paid by investments held in these accounts are not subject to dividend taxes.
The upside is that due to compounding, the deferred taxation of dividend payments can help your portfolio grow bigger, because more money will remain in your account, rather than going into Uncle Sam's pocket. However, you should know that withdrawals from traditional 401(k)s and traditional IRAs are taxed at ordinary income tax rates, and those rates may be higher (or lower) than the dividend tax rate you would otherwise pay, depending on your ordinary income tax bracket in retirement.
Because of this risk, a better way to own dividend paying stocks can be a Roth IRA or Roth 401(k). Unlike traditional accounts, Roth accounts are funded with after-tax money, and as long as withdrawal rules are followed, any dividend payments made to you in these accounts can be totally tax-free.
Staying on course
While no one likes to pay taxes, income taxes on dividends shouldn't keep you from investing in dividend-paying stocks. Dividend investing can be a great way to maximize your returns and build a larger nest egg over time -- especially if you focus on top-quality dividend-paying companies with a track record of dividend increases.
If your dividend payments are within taxable accounts, then plan ahead and set aside enough money to cover your tax bill. If you don't, you could be forced to sell your dividend-paying stock at precisely the wrong time in order to pay your taxes, and that's not a retirement-friendly move.