Dividends are payments that some companies make to their shareholders to reward them for their investment. Dividends can provide investors with regular, predictable income while preserving the opportunity to benefit from price increases. Dividends may qualify for favorable capital gains tax treatment if the shares are held long enough. Avoiding all income taxes on dividends is more complicated. Options include owning dividend stocks in a tax-advantaged retirement account or 529 plan. If your income is low enough, you can also avoid paying capital gains tax on certain dividend stocks altogether. A financial advisor can help you integrate dividend investing into your portfolio.
Dividends are payments that investors receive from owning shares in some companies. Companies that are profitable may choose to distribute a portion of their profits as cash or stock dividends to reward shareholders for investing in the company.
Dividend stocks are popular alternatives to bonds for investors looking to generate passive income. Retirees often invest in dividends to make a living without having to sell stocks.
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Like all income, dividends are subject to tax. Tax rates depend on whether dividends are considered qualified or nonqualified. Ordinary or unqualified dividends are paid on shares owned for less than the required holding period. Such dividends will be taxed at an investor's normal income tax rate. Qualifying dividends paid out of shares held for at least the required holding period are taxed as capital gains.
Capital yield rates are generally lower than normal income rates, ranging from 0% to 20%. Tax rates are based on taxpayer income and most taxpayers are in the 15% capital gains bracket. For example, an investor who earned $10,000 from qualifying dividends would typically owe $1,500 in capital gains taxes, reducing their after-tax profit 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 qualifying or regular dividends:
Roth Retirement Accounts. A Roth IRA is funded with after-tax funds. From the age of 59, the money can be withdrawn tax-free. Therefore, any dividends paid from shares held in a Roth account would be tax free provided the dividends were withdrawn after the age of 59½ and at least five years after the account was opened.
Eligible for Zero Capital Gains Tax. Capital gains tax is tiered, with higher-income investors paying higher rates. Investors in the lowest income bracket do not have to pay capital gains tax. The brackets change annually. For example, a married couple filing together and having taxable income of $89,250 or less in 2023 would not pay 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 would not have to pay tax on qualifying dividends.
educational plans. Tax-deferred 529 plans allow for tax-free growth and withdrawals as long as the money is used to pay for qualifying education expenses. So, if you deposit funds into a 529 plan and use the money to buy dividend stocks, you can accumulate funds tax-free and withdraw the funds with no tax liability, either. However, this only works if the withdrawal funds are used for qualifying educational expenses such as tuition and books.
Other Retirement Accounts. Other retirement accounts, such as traditional IRAs and 401(k)s, may offer a partial income tax exemption. These accounts are funded with pre-tax funds. An investor can deduct funds deposited into a traditional account from their current taxable income. But unlike Roth accounts, withdrawals are taxed as ordinary income. Holding dividend stocks in a traditional IRA or 401(k) won't eliminate your tax liability, but it could reduce it.
Investing in dividend stocks can generate income while preserving the potential for capital appreciation. Dividend income may be taxed at a rate of capital gains lower than ordinary income tax rates provided the Shares are held for at least one year. You may be able to avoid all income taxes on dividends if your income is low enough not to earn a capital gain by investing in a Roth retirement account or by buying dividend stocks in a tax-advantaged education account.
Consider contacting a financial advisor for suggestions on tax-efficient ways of earning income from dividend investing. SmartAsset's free tool connects you with up to three verified financial advisors in your area, and you can interview your appropriate advisor 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, get started now.
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How do I avoid paying tax on dividends? appeared first on the SmartAsset Blog.