The IRS makes you pay different tax rates on different types of income. As a result, it often makes sense to position yourself to earn income that falls into lower-tax categories. One of the biggest that ordinary investors can take advantage of is the lower rate on qualified dividend income, which can lead to your getting as much as 20 percentage points cut off your tax rate. Let's take a closer look at qualified dividends and how the average American investor managed to get preferential treatment for more than $6,200 of their dividend income.
How taxes on qualified dividends work
In the past, dividends were treated in the same way as interest and other investment income. Ordinary income tax rates applied to most investment income, subjecting them to the same taxes as wages and salary income.
The law governing dividends changed in 2003, creating lower rates for qualified dividends. Currently, qualified dividend carries a tax rate of 20% for those in the top 39.6% tax bracket. A 15% rate applies to those in the 25% to 35% brackets, while a 0% rate applies to those in the 10% and 15% brackets.
To be considered a qualified dividend, two criteria must apply. First, the dividend must come from a U.S. corporation, a corporation incorporated in a U.S. possession, or a foreign corporation that trades on a major U.S. stock exchange. Second, you must own the shares for at least 61 days out of the 121-day period that starts 60 days before the stock's ex-dividend date and ends 60 days after that date.
Also, some dividends are never qualified. These include capital gains distributions, dividends on credit-union or bank deposits, tax-exempt corporation dividends, and dividends on shares held under an Employee Stock Ownership Plan. Pass-through entities like real-estate investment trusts also typically have their income distributions retain their original character rather than being treated as qualified dividends for tax purposes.
Winning from qualified dividends
Millions of investors have taken advantage of lower tax rates on dividend payments. In the most recent year for which data are available, almost 25.5 million taxpayers took advantage of qualified dividends to reduce their tax rate. That amounted to more than 92% of all taxpayers earning dividend income, and all told, taxpayers got favorable treatment on more than $158 billion in dividends.
When you do the math, that amounts to an average of just over $6,200 in qualified dividends on every tax return that included them. The actual tax savings varies between 10 and 20 percentage points, and the IRS doesn't keep details on the tax brackets that applied to each tax return. However, based on the average qualified dividend income, savings would have ranged from $620 up to as much as $1,240.
What's most interesting is that even with that preference, most Americans seem to prefer interest income over dividend income. Almost 45 million Americans reported interest income in the most recent tax year for which data are available. Admittedly, the total amount of interest income is less, and given that banks must provide 1099-INT reports to the IRS for interest income of as little as $10, the disparity in income terms isn't as large as the sheer numbers would suggest.
Nevertheless, if you're not investing in dividend-paying stocks, you're missing out. Not only are you not getting favorable tax treatment, you're also giving up the much larger potential growth in your savings that you can get from a long-term investment in dividend stocks.
Sometimes, the IRS has to offer tax breaks to get you to do something you wouldn't otherwise want to do. But with qualified dividends, investors can get a valuable tax benefit on something they ought to be doing anyway. Start investing in high-quality dividend stocks now, and you can reap the financial and tax rewards well into the future.