Dividends are payments that some companies make to shareholders as a reward for investing in them. Dividends can provide regular, predictable income to investors who also retain the ability to profit from price appreciation. Dividends can benefit from favorable capital gains tax treatment if the shares are held long enough. Avoiding all dividend taxes is more complicated. Options include owning dividend-paying stocks in a tax-advantaged retirement account or 529 plan. You can also avoid paying capital gains tax on certain dividend-paying stocks if your income is low enough. A financial advisor can help you invest in dividends in your portfolio.
Dividend Basics
Dividends are payments that investors receive by owning shares of certain companies. Companies that are profitable may distribute a portion of their profits in the form of cash payments or stock dividends to reward shareholders for their investment in the company.
Dividend-paying stocks are popular alternatives to bonds for investors who want to generate passive income. Retirees often invest in dividends so they can pay living expenses without having to sell stocks.
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Like all income, dividends are subject to tax. Tax rates vary depending on whether the dividends are considered qualified or non-qualified. Ordinary or non-qualified dividends are paid by shares held for less than the required holding period. These dividends are taxed at an investor’s ordinary tax rate. Qualified dividends, which are paid by shares held for at least the required holding period, are taxed as capital gains.
Capital gains rates are generally lower than ordinary income rates and range from 0% to 20%. The rates are based on the taxpayer’s income and most taxpayers are in the 15% capital gains bracket. For example, an investor who earned $10,000 in eligible dividends would generally pay capital gains taxes of $1,500, which would reduce their after-tax gain to $8,500.
How to avoid taxes on dividends
There are a few strategies to avoid tax on your dividends, depending on whether they are eligible or ordinary dividends:
Roth retirement accounts. A Roth IRA is funded with after-tax money. Once a person turns 59.5, the money can be withdrawn tax-free. Thus, any dividends paid by shares held in a Roth account would be tax-free, provided the dividends are withdrawn after age 59.5 and at least five years after the account is opened.
Eligible for zero capital gains tax. Capital gains taxes are progressive, with higher income investors paying higher rates. Investors in the lowest income bracket do not owe any capital gains tax. The parentheses change every year. For example, a married couple filing jointly with taxable income of $89,250 or less in 2023 would pay no capital gains tax on dividends. Strategies such as contributions to retirement accounts and health savings accounts (HSAs) can reduce your income below the zero capital gains tax threshold. Therefore, you should not pay tax on eligible dividends.
Education projects. Tax-advantaged 529 plans allow tax-free growth and withdrawals as long as the money is used to pay eligible educational expenses. So putting funds into a 529 plan and using the money to buy dividend-paying stocks will allow you to accumulate funds tax-free and also withdraw the money tax-free. However, this only works if the amounts withdrawn are for qualified education expenses such as tuition and books.
Other retirement accounts. Other retirement accounts, like traditional IRAs and 401(k)s, may offer partial income tax relief. These accounts are funded with pre-tax money. An investor can deduct money paid into a traditional account from their current taxable income. But unlike Roth accounts, withdrawals are taxed as ordinary income. Holding dividend-paying stocks in a traditional IRA or 401(k) won’t eliminate your tax liability, but it could reduce it.
Conclusion
Investing in dividend-paying stocks can generate income while preserving the potential for capital appreciation. Dividend income may be taxed at lower capital gains rates than ordinary income tax rates as long as the shares are held for at least one year. You may be able to avoid all dividend taxes if your income is low enough to qualify for zero capital gains if you invest in a Roth retirement account or buy dividend-paying stocks in a tax-advantaged education account .
Investment advice
Consider consulting a financial advisor for suggestions on tax-efficient ways to generate income through dividend investing. SmartAsset’s free tool connects you with up to three approved financial advisors in your area, and you can interview your advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.
To properly plan your financial future, you need to have an idea of the value of your investments in the future. SmartAsset’s Investment Return and Growth Calculator can help you estimate the value of your portfolio. Include the amount of money you’re starting with, any additional contributions you plan to make, your expected rate of return, and how long you want the money to grow. The calculator will then give you the estimated future value of your portfolio.
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