Taxes on Dividend and Capital Income Explained

By Gaurav Sharma, BA | February 15, 2017

Tax on Dividend Income

When it comes to dividend investing, there are many things to consider before any investment is made. Dividend growth investors will look for a company that has a track record of increasing its dividend every year. If investors made the right choices last year, they will avoid paying a lot of tax on dividends 2016/17.

Meanwhile, those looking for a high-dividend-yield stock would want to ensure the dividend is safe based on if the revenue is recurring. They should also make sure that there isn’t a large amount of earnings being paid to satisfy investors, going by the payout ratio.

But no matter what type of dividend investor you are, there is one factor that must considered when researching investment opportunity: tax on dividend income.

Many investors tend to forget about tax on dividend income, which could be a big mistake, especially if there is a large tax bill at the end of the year. Over the long term, this could impact your net worth, and perhaps even more, based on your post-tax income.

This is why knowledge about taxes is very important and educating yourself is time well spent. Below is information on tax credits on dividends, tax on dividend income, tax rates on qualified dividends, and much more that could affect your bottom line.

What Is a “Qualified” Dividend?

Qualified dividends are paid to investors from U.S. equity securities and are generated from investments from common and preferred shares.

Dividends paid by certain foreign corporations may also be considered as a qualified dividends.

Below is a list of what type of stock investments would be considered as qualified dividends:

Corporations that are incorporated in the U.S. possession
Shares that are traded on U.S. exchanges through a American depositary receipt (ADR)
Shares traded on an established U.S. securities market
Corporations incorporated in a country having an income tax treaty with the U.S. (there might be withholding tax that is applied, depending on the rules of the country that the security is purchased in)
If an investment is made in a fund investment (mutual fund, exchange trade fund etc.) and it receives a qualified dividend, the dividend will be considered as being qualified when passed through to its investors

Income that is generated through a qualified dividend investment has a more favorable tax rate, which is detailed further below.

What Would Be a “Non-Qualified” Dividend Investment?

Examples of non-qualified dividend investments are:

Capital gain distributions.
Dividends paid on deposits with mutual savings banks, cooperative banks, credit unions, U.S. building and loan associations, U.S. savings and loan associations, and federal savings and loan associations (these would be considered interest income)
Dividends from a tax-exempt organization or agricultural cooperative
Dividends paid by a corporation on employer securities held by an employee stock ownership plan (ESOP) which is handled by the corporation
Dividends which are supposed to be paid out, such as a short sale
Distributions from partnership and real estate investment trust (REIT) are considered as non-qualified dividend income
Held preferred debt of a company would also be considered a non-qualified investment

It is also very important to keep in mind that foreign corporate dividends may be subject to a foreign withholding tax. This is based on the country of investment and its rules for foreign investments.

Below is more information on the tax rate that would be applied to non-qualified investments.

Is There a Required Holding Period for Qualified Dividends?

In order to receive special tax treatment, investors must satisfy a certain holding period, depending on the type of stocks that are held.

When it comes to common stocks, shareholders must own the stock for more than a 60-day period, including the ex-dividend date. For preferred stocks, stocks must be owned for over 90 days; this includes the ex-dividend date as well

It is important to monitor your holding period if you are an active trader because the dividend payment may be classified as a non-qualifying dividend.

How Are Dividend Stocks Taxed?

When it comes to paying taxes on income, not all dividend stocks are the same. The tax rate paid on dividend income is based on the rate that is charged on your ordinary income. Below is a chart detailing the rate that would be charged on your dividend income:

Single Reported Taxable Income	Married (Joint) Taxable Income	Tax Rate on Ordinary Income	Qualified Dividend-Paying Stock Tax Rate	Non-Qualified Dividend-Paying Stock Tax Rate
$0.00–$9,275	$0.00–$18,550	10%	0%	10%
$9,276–$37,650	$18,551–$75,300	15%	0%	15%
$37,651–$91,150	$75,301–$151,900	25%	15%	25%
$91,151–$190,150	$151,901–$231,450	28%	15%	28%
$190,151–$413,350	$231,451–$413,350	33%	15%	33%
$413-,351–$415,050	$413,351–$466,950	35%	15%	35%
$415,051 or more	$466,950 or more	39.6%	20%	39.6%

Benefits of Qualified Dividends Over Non-Qualified Dividend Investments

Consider an investor in the 35% tax rate bracket who owns $500,000 worth of dividend stocks, which pay an average yield of five percent annually. The investor will receive $25,000 in annual dividends.

If the dividend investments are non-qualified dividend stocks, the tax bill for the investor would be $8.750; this would result in having$16,250 after taxes are paid. However, if the investments are qualified dividend stocks, the tax bill would instead be $3,750, meaning $21,250 after paying taxes.

Based on this example, the investor would have an additional $5,000, or 30%, of capital if the entire portfolio was invested in qualified dividend-paying stocks. Over the long term, your total net worth could be greatly impacted by owning qualified paying stocks, which have a lower tax rate.

Can Dividend Income Be Offset by Capital Losses?

Capital losses and dividends cannot be used to offset one another directly because they are considered different sources of income.

Capital losses could be used to offset any gains that are generated in one’s portfolio. For example, if you purchased a company and made a profit of $1,000, then sold another company and realized a loss of $800.00, this would result in a total capital gain of $200.00.

There is one scenario which capital losses may be applied to dividend income. If there is a capital loss of up to $3,000, then it could be applied to regular taxable income, which may also include dividends.

What Is a Dividend Reinvestment Plan? How Are Taxes Applied?

A dividend reinvestment plan (DRIP) enables shareholders to use a company’s dividend to acquire more shares of that business, rather than receiving the dividend in cash.

Enrollment in a DRIP must be done after making the purchase of the shares through your broker. With mutual funds, this dividend is automatically set up to reinvest back into the fund.

Taxes on a DRIP depend on how the shares are being purchased, and are applied two different ways. Dividends used to buy more stocks at the fair market value must be reported as income, while those bought at a discount are to be reported as dividend income.

As each dividend is used to automatically reinvest to acquire more stock, the investor’s cost basis in impacted, since shares are most likely purchased at different prices. So when the shares are sold, there will be a capital gain or loss that will be calculated based on the difference between the selling price and the average cost basis.

Would a Return on Capital Be Considered as a “Qualified” Dividend?

The simple answer is “no.” Rather, this would be capital that is returned from mutual funds, exchange-traded funds (ETFs), limited partnerships, and REITs.

A return on capital is a return of some or all your investments made into the stock of a company. The return on capital reduces the adjusted cost basis on your overall investment.

Would Capital Gain Distributions Be Considered as a “Qualified” Dividend?

Capital gain distributions can be expected from mutual funds, ETFs, limited partnerships, and REITs. Capital gains distributions would not be considered a qualified dividend, but rather long-term capital gains.

How Is Capital Gain/Loss Determined? How Do I Calculate Adjusted Cost Basis?

When a stock is sold, the difference between the selling amount and the adjusted cost base is used to determine the capital gain or loss for the investment. Below is an example of how to determine capital gain, capital loss, and the adjusted cost base.

The example below would be considered a capital gain. The investor would calculate a capital gain of $500.00 ($1,500–$1,000). The shares were purchased at $1,000 and sold at $1,500.

	Price	Number of Shares	Total Cost
Initial Purchase	$1.00	1000	$1,000.00
Sold The Entire Position	$1.50	1000	$1,500.00

This example would be a capital loss. The investor would calculate a capital loss of $600.00 ($1,400–$2,000) after buying the shares at $2,000 and selling them at $1,400.

	Price	Number of Shares	Total Cost
Initial Purchase	$20.00	100	$2,000.00
Sold The Entire Position	$14.00	100	$1,400.00

The following example is how the adjusted cost base is calculated. The first purchase was for $10.00 and the second was for $12.00 and the same number of shares. This results in an average cost base of $11.00 for this investor ($10.00 + $12.00/2 =$11.00).

	Price	Number of Shares	Total Cost
Initial Purchase	$10.00	100	$1,000.00
Second Purchase	$12.00	100	$1,200.00

How Are Stock Options and Stock Dividends Treated from a Tax Perspective?

Distributions by a corporation of its own stock are known as stock dividends. The general rule is that there are no taxes on these, unless one of the following applies:

You have a choice of receiving cash instead of stocks
The distribution can be converted into preferred stocks
If some common stockholders receive preferred stock at the same time that others receive common stocks
If the distribution is on preferred stocks

How Are Share Repurchases Taxes?

No taxes need to be reported when a company announces share buybacks. In fact, repurchases are a tax-efficient method of returning money to shareholders, who end up owning a larger amount of the company. Taxes are due when the shares are sold and the capital gain or loss must be reported.

Advice to Take Away

It is very important to understand how different types of dividend investments are taxed so there are no surprises when it is time to file your tax return. There are many tax advantages to owning a qualified dividend stock, but you should also consider if the investment is appropriate for your risk tolerance and investment goals.

Before purchasing a dividend-paying stock, remember to consider if it is an appropriate investment for your portfolio and take time to look at all aspects so there are no surprises, including taxes, risk, return expectations, and deadlines.