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 and 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 qualifying foreign company
- They cannot be unqualified dividends
- They must pass the holding period (61 days during the 121-day period as of the 60 days before the ex-dividend date or 91 days out of the 181-day period 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. The following chart outlines the capital gains tax rates, annual income thresholds, and filing status.
| Capital Gains Tax Rate | Annual Income Range | Filing Status |
| 0% | $0 to $40,400 | Single |
| $0 to $80,800 | Married Filing Jointly | |
| 15% | $40,400 to $445,850 | Single |
| $40,400 to $250,800 | Married Filing Separately | |
| $54,100 to $473,750 | Head of Household | |
| $80,800 to $501,600 | Married Filing Jointly |
Source: Internal Revenue Service
The Internal Revenue Service (IRS) imposes a 20% capital gains tax rate for filers who exceed the 15% threshold.
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.
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. The tax rates for 2022 in the United States are:
| 2022 Marginal Tax Rates | ||
|---|---|---|
| Tax Rate | Income Range (Single) | Income Range (Married Filing Jointly) |
| 10% | $10,275 or less | $20,550 or less |
| 12% | $10,276 to $41,775 | $20,551 to $83,550 |
| 22% | $41,776 to $89,075 | $83,551 to $178,150 |
| 24% | $89,076 to $170,050 | $178,151 to $340,100 |
| 32% | $170,051 to $215,950 | $340,101 to $431,900 |
| 35% | $215,951 to $539,900 | $431,901 to $647,850 |
| 37% | $539,900 and above | $647,850 and above |
Source: Internal Revenue Service
The company that pays you ordinary dividends will send you Form 1099-DIV. Ordinary dividends are reported in Box 1a. These are inputted on line 3b of your Form 1040.
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 held the stock and whether the dividends are considered qualified or ordinary.
Article Sources
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Internal Revenue Service. "Topic No. 404: Dividends."
Internal Revenue Service. "Topic No. 409: Capital Gains and Losses."
Internal Revenue Service. "About Form 1099-DIV, Dividends and Distributions."
Internal Revenue Service. "Form 1040: U.S. Individual Income Tax Return."
Internal Revenue Service. "Publication 550: Investment Income and Expenses," Page 20.
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