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Some of the world’s largest and most successful companies offer dividends. Dividends are distributions on earnings made by certain companies to their shareholders. These companies effectively reward their investors by sharing a portion of their earnings. This stream of income, no matter how small, is one of the reasons why investors love dividends.
But what should you do with your dividends when you receive them? Should you cash them out or reinvest them? Cashing them out leads to further complexities as they may be considered qualified dividends or ordinary dividends.
Understanding how dividends are categorized is key to making an informed decision on whether to reinvest them or cash them out for tax purposes. In this article, we explore how these categories are taxed so you can make an informed decision about how to navigate your dividends.
Key Takeaways
- Dividends are distributions paid by companies on earnings to their investors.
- Investors can choose to reinvest their dividends or take them in cash.
- Cash dividends are categorized as qualified or ordinary.
- Qualified dividends are taxed at lower rates than ordinary dividends, which are considered ordinary income.
- Reinvested dividends are treated as if you actually received the cash and are taxed accordingly.
Taxes on Qualified Dividends
A cash dividend can fall into two categories, one of which is the qualified dividend. This type of dividend is subject to taxation at a lower rate than ordinary income. As such, investors are responsible for paying the applicable capital gains tax rate on their qualified distributions.
A capital gain is an increase in the value of a capital asset, such as real estate or an investment, above the amount paid for the asset.
Qualified dividends meet several key criteria:
- They must be paid by an American or a qualifying foreign company
- They cannot be unqualified dividends
- They must pass the holding period (61 days during the 121 days as of the 60 days before the ex-dividend date or 91 days out of the 181 days for preferred stock)
The rate at which you’re taxed on a qualified dividend and, therefore, the amount of tax you owe, depends on your annual income, which corresponds to one of three capital gains tax rates: 0%, 15%, or 20%.
Dividend-paying companies send investors copies of Form 1099-DIV: Dividends and Distributions. Qualified dividends are reported in Box 1b. These are inputted on line 3a of your Form 1040.
Important
There is a difference between realized and unrealized capital gains. A gain is not realized until the asset is sold and the tax is generally not paid until after the gain is realized.
Taxes on Ordinary Dividends
Ordinary dividends are the other type of cash dividend. Dividends are generally considered ordinary by default. Those that don’t meet the criteria to be classified as qualified dividends are taxed as ordinary income. This type of income also includes income received from wages, salaries, commissions, and interest income from bonds.
The following aren’t considered qualified dividends:
- Capital gains distributions
- Any dividends paid on deposits with credit unions and certain other financial institutions
- Any dividends from a nonprofit organization or other tax-exempt corporation
- Dividends paid by a corporation on securities that an employee holds in an employee stock ownership plan maintained by the corporation
- Dividends on shares of stock where the holder is required to make related payments
- Dividends from foreign corporations
Since they are taxed as ordinary income, ordinary dividends are taxed at your marginal tax rate, which, depending on your income, is 10%, 12%, 22%, 24%, 32%, 35%, or 37%.
Note
You can offset your ordinary income by using standard deductions. Income from capital gains, on the other hand, can only be offset by capital losses.
Taxes on Dividend Reinvestment
Some investors choose to reinvest their dividends. This is a process that takes cash dividends and automatically purchases additional shares in the same company rather than paying them out to the investor. But if you think you’re free from paying taxes on your reinvested dividends, think again.
Choosing to reinvest your dividends is akin to receiving them in cash. And the way they are taxed depends on whether they are deemed ordinary or qualified. Remember, your dividends must meet certain criteria to be deemed qualified, which means they are taxed at the capital gains tax rate. Ordinary dividends that are reinvested are taxed as ordinary income.
This includes any dividend reinvestment plans (DRIPs) in which you participate. DRIPs allow investors to purchase additional shares of stock at below-market prices. In these cases, the difference between the cash reinvested and the fair market value (FMV) of the stock is taxed as ordinary dividend income.
Keep in mind that some companies don’t offer investors the option of taking cash. Instead, these companies pay shareholders dividends only in the form of additional shares. These stock dividends are not taxable when they are received. Rather, investors pay taxes when they sell their stock. If the investor does have the option of taking cash and stock but chooses the former, they are taxed accordingly.
Are Reinvested Dividends Taxable?
Reinvested dividends are treated the same way as cash dividends. The way they are taxed depends on whether they are considered ordinary or qualified dividends. If you participate in a dividend reinvestment plan, you may only be responsible for paying taxes on the difference between the shares’ fair market value and the purchase price, which is normally below market value. This amount is taxed as ordinary income.
How Do You Pay Taxes on a Fund That Reinvests Dividends?
Dividends are taxable regardless of whether you take them in cash or reinvest them in the mutual fund that pays them out. You incur the tax liability in the year in which the dividends are reinvested. If the company allows you to purchase shares at below-market prices, you’ll only pay ordinary income (if they’re not considered qualified dividends) on the difference between the fair market value and the purchase price.
How Are Reinvested Dividends Taxed if the Security Is Sold?
You must pay taxes on any securities that you sell, including any that were previously reinvested. Your tax rate depends on how long you hold the stock and whether the dividends are considered qualified or ordinary.
The Bottom Line
Companies that pay dividends provide a positive feature to stocks as the income stream is guaranteed regardless of stock appreciation. Investors have the option to take dividends as cash or to reinvest them in the form of additional shares of stock.
It’s important to be aware of the tax considerations of both options as reinvested dividends are taxed as if you received cash dividends. Whether they are taxed at ordinary tax rates or the lower capital gains tax rates will depend on whether the dividends are ordinary or qualified.
