How to Keep More Money in Your Pockets
Uncle Sam has extended this year’s tax deadline into May. By the time you read this, you will have about three more weeks left to file your taxes.
If you sold any stocks for a gain or if you received any dividends in a taxable account, you will owe taxes on those. In regards to the dividend, your broker will give you a handy Form 1099-DIV that will tell you the dividend income you received in the past year. In that sense, it is pretty easy to account for dividends on your tax return.
You probably already know that long-term and short-term gains are taxed differently, but did you also know that your dividends are taxed differently too? Look closely at your 1099-DIV and you will see separate boxes for “ordinary” and “qualified” dividend.
The numbers in the two boxes show the gross amount. What matters to you the most is the net amount, i.e. what goes into your pockets after Uncle Sam gets his cut. Depending on your tax bracket, the tax difference between ordinary vs. qualified dividend can be quite significant.
Tax Treatment Difference a Big Deal
Ordinary dividends (aka “unqualified” and “non-qualified” dividends) are taxed at your ordinary income rate. Whatever income bracket you belong to, that’s the rate you pay on ordinary dividends. This means that on the federal level, you could be paying as low as 10% and as high as 37% on your ordinary dividend. Again, the rate you pay depends on your income level for the year.
On the other hand, qualified dividend is taxed at the (long-term) capital gains rate. This is important because the way the tax rates are structured in the U.S., no matter which tax bracket you belong to, your capital gains tax rate will always be lower than your ordinary income tax rate.
Sources of Tables: Turbo Tax
Take a careful look at the tables to check what tax bracket you fall in and see how your ordinary and qualified dividends will be taxed differently.
Let’s say you are married and filing jointly with your spouse and your combined taxable income is $75,000, you are in the 12% tax bracket so your ordinary dividend would be taxed at 12%. But your qualified dividend would be tax exempt! Or let’s say you and your spouse jointly have $350,000 in taxable income, the difference would be 32% vs. 15%! No matter how much you make, your qualified dividends will not be taxed at higher than 20%.
What Makes a Dividend Qualified?
To be recognized as a qualified, a dividend has to meet certain IRS requirements. The main requirement that you have direct control over is the timing of the purchase and holding period.
Here’s a direct quote from the IRS about what is not a qualified dividend:
Dividends the recipient received on any share of stock held for less than 61 days during the 121-day period that began 60 days before the ex-dividend date.
Yes, that sounds downright confusing. Let’s try to break it down.
First, you have to find out what the stock’s next ex-dividend date will be. Keep in mind that in the U.S. the ex-dividend date is one trading day before the record date. When a company declares a dividend, they will say shareholders of record as of a certain date will be entitled to the dividend. This will allow you to know when the ex-dividend date is.
Work Out the Math
Let’s say that company XYZ declares a $1 dividend and says that shareholders of record on April 22, 2021 will receive the dividend. Since it takes stocks two trading days to settle, this means that April 20 is the last day you can purchase shares and still receive the upcoming dividend. Put another way, people who purchase on April 21 or later do not get the upcoming declared dividend. This is why the trading day before the record date is the ex-dividend date.
Once you know the ex-dividend date, then just count 60 days backward and 60 days forward from that date. This whole period is the 121-day period the IRS refers to. If you hold the stock for at least 61 days during this period, then the dividend received meets the qualified dividend requirement. Beware, when you count days for your holding period, do not count the day you purchased the stock. Start counting with the day after.
More Points to Consider
Note that even foreign dividend, if they are paid by a qualifying foreign corporation, can be qualified dividend. A foreign company qualifies if it is incorporated in a U.S. possession or if it’s widely traded on a major stock exchange. So chances are good that the foreign dividend you are receiving qualifies if you satisfy the holding period requirement.
Dividend paid by certain types of entities like real estate investment trusts (REITs) automatically don’t qualify as qualified dividend. This doesn’t mean that you should avoid them. If they are a good company and pay a high dividend, even with the higher tax rate, the net dividend received may still be better than what you get from another company.
Lastly, if you have doubts about the tax treatment of your dividends, check with you accountant.
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