Investing in dividend-paying stocks is one of the simplest ways to earn an extra stream of income. But like most income, it's not free money. You'll have to share a piece of your earnings with the IRS in the form of taxes.
Fortunately, there are ways to trim your tax bill by understanding the ins and outs of how taxes on dividend stocks work.
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Earn more qualified dividends
There are thousands of dividend stocks to choose from, but all dividends are not created equally. If you're aiming to lower your taxes, qualified dividends are your best friend. Unlike ordinary dividends, a qualified dividend allows you to unlock the same rates as long-term capital gains. You'll gain access to the 0%, 15%, and 20% tax brackets instead of the regular federal income tax rates that could be as high as 37%.
There are special rules that need to be followed to enjoy the benefits of qualified dividends. To sum it up, a dividend is usually considered qualified if it's an ordinary dividend paid by a U.S. corporation or a qualified foreign corporation whose shares are listed on a major U.S. exchange. The underlying stock in your portfolio must be held more than 60 days during the 121-day period that began 60 days before the ex-dividend date.
Benefit from your tax bracket
Your taxable income may qualify you for a lower tax rate on dividends. If you are single and earn $445,850 or less in taxable income in 2021, you qualify for the 15% tax bracket on dividends. That number increases to $501,600 of taxable income that can be earned if you are a married couple filing together.
However, the tax brackets and rates truly work in your favor if you earn under $40,400 as a single filer and $80,800 as a married filer. You become eligible for the 0% tax rate on qualified dividends. That means you don't have to pay any income tax on those dividend deposits that flow into your account. The 2021 qualified dividend tax brackets are listed below to help you identify ways to minimize your taxes.
2021 qualified dividends tax brackets
|
For single filers with taxable income of... |
For married joint filers with taxable income of... |
For heads of households with taxable income of... |
...this is the 2021 tax rate on qualified dividends |
|---|---|---|---|
|
$0 to $40,400 |
$0 to $80,800 |
$0 to $54,100 |
0% |
|
$40,401 to $445,850 |
$80,801 to $501,600 |
$54,101 to $473,750 |
15% |
|
Over $445,851 |
Over $501,601 |
Over $473,751 |
20% |
Data source: IRS.
Open a tax-advantaged account
If you own stocks in a taxable brokerage account, then you'll pay taxes on dividends as you go. But you can defer or skip the tax pain altogether by investing in an IRA. Traditional IRAs won't charge you taxes until you withdraw money from the account. Roth IRAs are even better, as this special IRA allows you to contribute money you've already paid taxes on and grow that money tax-free. All the money in the account is yours to keep after you reach 59 1/2 and have met the five-year rule.
To qualify for a Roth IRA, you need earned income for the year and your income has to fall below the thresholds. Other than that, you can start contributing up to the maximum amount into your Roth IRA every year, invest the money, and collect dividend income in your account without worrying about an annual tax bill.
Earn more money in your sleep
Dividends provide a phenomenal opportunity to earn more money without adding more work to your to-do list. You'll also get the additional benefits of paying less taxes on dividend income than you would from working a job. If you're ready to invest in dividend-paying stocks or grow your portfolio, the tax benefits provide a great incentive to get started now. It's the perfect tax strategy to implement if you want to earn more income without drastically increasing your tax bill.
