Tax season is here, and over the next few months, millions of taxpayers will scour the tax laws to find whatever strategies they can to reduce the amount they have to pay the IRS. Many average Americans never bother looking too closely for tax breaks, figuring that all the good ones are reserved for the rich. Although many provisions do help those who have more income to claim, you can find several lucrative tax breaks that not only benefit ordinary people but also spur them to build up their wealth to reap even more tax savings.
One such provision is the reduced tax rate on qualified dividends. Any investor with a stock portfolio can take advantage of this favorable tax law to earn dividend income at a reduced rate, and some can even turn dividends into tax-free income. With one out of every six taxpayers using this tax break, it's available not just to the rich but also to those who aspire to join their ranks in the long run.
Why qualified dividends are worth looking for
For more than 15 years now, the tax laws have given investors an incentive to invest in stocks that pay dividends over other types of investments. Most investment income from sources like bonds, bank accounts, and rental real estate gets taxed at the same rate that you pay on your earnings from work, which on your 2017 tax return will be as high as 39.6%.
Qualified dividend income gets much lower tax rates. For those who are in that top 39.6% bracket, a maximum rate of 20% applies to qualified dividends. The favorable rate is 15% for those who are in the 25%, 28%, 33%, or 35% tax brackets for 2017. And if you're fortunate enough to be in the 10% or 15% brackets for ordinary income, then you'll get the best news of all: Tax-free treatment on your qualified dividend income.
How to get qualified dividends
Just because you get a dividend from one of your portfolio holdings doesn't automatically mean that it lets you take advantage of the qualified dividend rate. It's therefore crucial that you understand the restrictions before you go out and by a certain dividend-paying stock or other investment.
First, the company that pays you the dividend has to meet the geographical test for qualified dividend payers. All U.S. corporations pass this test, as do corporations that are incorporated in U.S. possessions. Foreign companies also meet this requirement if their stock trades on a major stock exchange within the U.S., such as the New York Stock Exchange or Nasdaq Stock Market.
Second, the company paying the dividend can't belong to certain special types. For instance, distributions that pass-through entities such as partnerships, limited liability companies, real estate investment trusts, and regulated investment companies make generally take on the tax characteristics from the business entities that received that income and passed it through to their investors. Therefore, if a REIT earns rental income that's generally taxed at ordinary income rates, the fact that it gets paid as a dividend to the REIT's shareholders doesn't transform that income into tax-favored qualified dividend income.
Finally, you have to own the stock that paid the dividend for a certain minimum period of time. The tax law requires you to hold the stock for 61 days out of the period that starts 60 days before the date on which the shares trade ex-dividend, and ends 60 days after the ex-dividend date. That prevents short-term traders from taking advantage of the preferential qualified dividend rate.
Hundreds of billions in qualified dividends
The amount of money available as a tax break for qualified dividends isn't trivial. Almost $203.2 billion in qualified dividends got reported on tax returns for the 2015 tax year, according to the most recent IRS data. Almost 25.8 million taxpayers claimed qualified dividend income on their tax returns, amounting to an average of $7,889 for the typical investor.
The amount of tax savings will depend on your particular tax situation. Yet based on those averages, the minimum savings would be almost $800, and some taxpayers could save close to $1,600 using the rules governing qualified dividends.
When you're first starting out, you probably won't be able to earn nearly $8,000 in dividend income right away. Over time, though, looking at stocks that grow their dividends can help you use the power of compound returns to your advantage, letting you not only reinvest dividends into additional shares but also use future savings to buy even more dividend stocks at preferential tax rates.
Get started with stock investing
Given the wealth-making power of stocks, lower tax rates on qualified dividend income are just icing on the cake for savvy investors. By tapping into this tax break, you'll get yourself on the path toward financial independence in the long run.