We’re only a few months away from tax season again. You can’t avoid death and taxes but you can reduce your liability by taking the time to understand our intricate tax system. If you’ve followed our advice and created a rock-solid dividend portfolio that pays you a monthly paycheck, here’s what you need to know about taxes:
The tax system basically identifies two types of dividends – ordinary and qualified. Qualified dividends are basically rooted in policies set by the Bush-administration in the early-2000’s. Qualified dividends are meant to be treated the same way as capital gains. That means the tax rate on capital gains and dividends is the same – usually about 15%.
Each year you’ll receive a 1099-DIV form, which will have to be filled out with details on your dividend income for the IRS. The form covers a whole range of possible distributions – from liquidation distributions to foreign taxes – but we’ll be focusing on ordinary and qualified dividends for this article.
Ordinary dividends are pretty straightforward. They are paid from the company’s earnings and can come through to you because you hold stocks or mutual funds. These are classified as ordinary income, not capital gains, which means you’ll pay taxes on this income the same way you would pay taxes on income from your day job.
For most people the dividends they receive is most likely an ordinary dividend. If the dividend payer tells you otherwise that could be the only indication that your dividend is something else – most likely a qualified dividend.
Qualified dividends are taxed more favorably than ordinary dividends. This is basically because dividends in this class are treated like long-term capital gains. To qualify for these the stocks or assets that pay the dividend must originate from a US corporation or a qualified corporation. The stocks or assets must also be held for a minimum of 61 days in the past 121-day period. This 121-day window starts from the ex-dividend date, which is why dividend capture won’t work.
If the dividends you receive come from stocks that fit these categories you can declare them on the line 1b of your 1099-DIV form.
Remember capital gains are taxed at 15%, so there’s a good chance you’ll save money if you earn qualified dividends. If you’re in the 35% tax bracket, a $10,000 payment would imply a $3,500 tax if it’s ordinary. But if it’s a qualified dividend, you only owe $1,500.
Don’t underestimate the power of compounding if you simply use these dividends and the tax savings on reinvesting into the company.
There can never really be a tax policy without certain complex exemptions. Most dividends you encounter will fall into the qualified or ordinary basket. But there are a few caveats.
Preferred shares are a good place to start. You need to hold preferred shares for at least 91 days in the past 181-day window to qualify dividends paid on them. That means you have to hold onto preferred shares for a bit longer to get the tax break.
Capital gains distributions, dividends paid as interest income from banks, dividends from tax-exempt organizations (like charities), payments in lieu of dividends, and dividends paid as part of an employee stock ownership plan (ESOP), are all disqualified. These dividends must be treated as ordinary dividends regardless of how long you’ve held the stocks.
If all this should tell you one thing it’s that being a long-term investor pays off. The government is willing to tax you less on dividends as long as you can show a long-term commitment to the shares you buy.
Even if you can shave off just a few percentage points from the tax bill on dividends, you’ll end up with a tremendous boost to your compounded returns.
This complicated tax policy was built to extract more taxes from reckless day-traders and wall street bankers, while reducing the burden on pensioners who probably live off the dividend income.
Qualified dividends from blue chip companies are the best way to live off your wealth forever.