With taxes and dividend income, seasoned investors have learned the special qualified dividend treatment can increase their after-tax return. They tend to find some dividend-paying stocks and mutual funds attractive because their total return includes both the dividend and any market price appreciation.
However, investors whose income exceeds certain thresholds need to keep an eye on the additional 3.8% Medicare surcharge. As of Jan. 1, 2013, single taxpayers with Modified Adjusted Gross Income (MAGI) of $200,000 and married couples with MAGI in excess of $250,000 are subject to an additional 3.8% Medicare surcharge on net investment income (which includes all taxable dividends).
For tax purposes, it’s important to know dividends are considered either “qualified” or “nonqualified.” Qualified dividends are:
- Tax-free for those with income falling within the 10% and 15% brackets to the extent qualified dividend income remains within those brackets
- Taxed at a 15% rate for those with income falling within the 25% to 39.6% tax brackets
- Taxed at a 20% rate for higher income taxpayers whose income surpasses the 39.6% tax bracket
Nonqualified dividends are taxed at the same rates as ordinary income (currently a 39.6% maximum).
What’s a ‘qualified’ dividend?
Qualified dividends are paid to investors in common and preferred stock of U.S. corporations where the income is derived from U.S. equity securities. Dividends passed through by mutual funds or other regulated investment companies can be qualified or nonqualified, depending on the underlying securities held by the fund.
If a fund receives a qualified dividend, the dividend will maintain its qualified status when passed through to shareholders. Distributions from partnerships and real estate investment trusts typically are not characterized as qualified dividends. Also, qualified dividends do not include distributions from preferred debt.
Dividends paid by certain foreign corporations may also be qualified. Examples include:
- Shares represented by a publicly traded American Depositary Receipt (ADR)
- Shares are otherwise readily tradable on an established U.S. securities market
- Corporations incorporated in a U.S. possession
- Corporations incorporated in a country having an income-tax treaty with the United States containing an exchange of information program approved by the U.S. Treasury
Keep in mind that the foreign corporate dividend may remain subject to foreign tax withholding.
It’s critical to obtain proper tax classification of an investment to determine whether the dividend is qualified.
How does the qualified dividend tax treatment work?
For example, Jake has $66,100 in annual taxable income, excluding his dividends. Because he’s married and files a joint return, he would be in the 15% federal tax bracket. However, his $9,000 in qualified dividends pushes his total income in excess of $74,900, which pushes his income to within the level of the 25% tax bracket. As a result, $8,800 of Jake’s qualified dividends would be tax-free, while the remaining $200 [$75,100 (his total income) - $74,900] would be taxed at 15%.¹
Is there a required holding period?
To qualify for the special tax treatment, shareholders must satisfy a certain holding period² based on the type of stock held:
- For common stock, shareholders must own the stock for more than a 60-day period containing the ex-dividend date.
- For preferred stock, the owner must hold the shares for more than a 90-day period including the ex-dividend date.
Active traders should monitor their holding periods carefully to benefit from the qualified-dividend tax treatment.
Capital losses and offsetting qualified dividends
Although dividends and long-term capital gains are taxed at the same rates, this does not mean capital losses can be used to offset dividends. However, if you have a net capital loss after offsetting all capital gains, up to $3,000 per year of capital loss may offset regular taxable income which may include dividends. When calculating the 3.8% Medicare surtax, the $3,000 additional capital loss cannot offset dividends.
Get the right advice
It’s important to understand how dividends are taxed – this is only a brief summary. For more detailed information, contact your tax advisor. Keep in mind taxes certainly affect investment returns. The effects of taxes should be only one of many factors you consider when making investment decisions.
There are tax advantages to owning a qualified-dividend-paying stock – but that alone doesn’t make the stock appropriate for your portfolio. Before you make an investment, your financial advisor will work with you to consider a variety of factors, such as your long-term goals, time horizon, and risk tolerance, in addition to the tax implications.
¹Although this example is conceptually accurate, the actual tax calculation Jake would perform on his tax forms would involve a separate worksheet to determine the amount of the qualified dividends that would be categorized and taxed at various rates.
²When a stock trades ex-dividend, the dividend, when paid, goes to the seller. In general, the exchange designates a stock as ex-dividend a few days before the record date. Certain hedge positions may suspend the holding period for this purpose.
Our firm is not a tax or legal advisor. While this information is not intended to replace your discussions with your tax advisor, it may help you to comprehend the tax implications of your investments and plan efficiently going forward.
Dividends are not guaranteed and are subject to change or elimination.
This article was written by a third party and provided courtesy Jason Steele and Harry O'Conner in Raleigh, NC at 919-783-8500.
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