Taxes on Dividends: Ways to Pay and Ways to Avoid

The Tax Man cometh.  It’s that time of year that many Americans are rushing to finish their tax returns.  For dividend investors there is the added step of reporting and paying taxes on dividends received for the prior year in addition to our regular employment income.

As your dividend income rises, the tax bill that is due becomes larger as well and attention is needed to ensure that you have enough funds to pay.

When your dividend income is low, it is easy to absorb the taxes into your regular income tax, but at a certain point the taxes become more than you can absorb with your regular income tax.  Personally, my dividend income is getting to the level where the taxes due is becoming a real factor to consider and plan for.

With this in mind, I wanted to review the options we have to pay for taxes on dividends to compensate for and plan for these additional tax liabilities.

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Taxes on dividends

But first, I wanted to go over the basic tax requirements for dividends in the United States (for other countries the tax laws and requirements are much different).  Note that these requirements are as of today and may be different in the future and for your situation.  This is not tax advice and should be viewed as informational only.  Consult a tax advisor for your particular situation.

Once you receive $10 or more in dividends in a non-retirement account in a year, your broker is required to report your dividend income in a 1099-Div form.  As a taxpayer, you are required to report this income on your tax return.  Even if the dividend is reinvested, you are still required to pay taxes on the income.  For more info, check out the IRS’s website.

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Types of dividends 

There are two types of dividends, qualified and ordinary.

Per Investopedia, a qualified dividend has to meet the following:

• The dividend must have been paid by a U.S. company or a qualifying foreign company.
• The dividends are not listed with the IRS as those that do not qualify.
• The required dividend holding period has been met.
  • For common stock, the holding must exceed 60 days throughout the 120-day period, which begins 60 days before the ex-dividend date. Preferred stock must have a holding period of at least 90 days during the 180-day period that begins 90 days before the stock’s ex-dividend date.

The current tax rates for qualified dividends depends on your taxable income levels.

	0% tax rate	15% tax rate	20% tax rate
Single	$0 to $44,625.	$44,626 to $492,300.	$492,301 or more.
Married, filing jointly	$0 to $89,250.	$89,251 to $553,850.	$553,851 or more.
Married, filing separately	$0 to $44,625.	$44,626 to $276,900.	$276,901 or more.
Head of household	$0 to $59,750.	$59,751 to $523,050.	$523,051 or more.

Source

Ordinary dividends are everything else and are taxed at your regular income tax rate, and include such companies as MLPs, REITs, and other foreign companies.

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Dividends for Minors

For minors, the tax rates are different.  

Income from investments (interest, dividends and capital gains) are taxed based on how much they earn.

• If the child has no earned income, the amount of unearned income (investment income) up to $1,250 is not taxed in 2023.
• The next $1,250 is taxed at the child’s rate.
• Any amount above $2,500 is taxed at the parents’ rate.

These rules affect children under the age of 18, and those who are full-time students up to age of 24. 

Once the child is over 18 (or no longer a student), the dividends will be taxed as an adult and will follow the same guidelines as listed above for qualified and ordinary dividends, based on the child’s (now an adult) taxable income levels.

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Dividends in retirement accounts

One way to avoid (or delay) paying taxes on dividends is by investing through individual retirement accounts (IRAs).

For traditional IRAs, you do not pay taxes on the dividends until you take them out of the IRA after 59 ½ years old.  When you do take them out, you will be taxed at your regular income tax rate at that time. You will not qualify for the qualified dividend tax rates.

For ROTH IRAs, you do not have to ever pay taxes on your dividend income but you are unable to use them until 59 ½ or older. 

These are both great tools to use to grow your dividend income but remember there are restrictions on when you can take them out.  If you withdraw the dividends before 59 ½ you will get a penalty and be taxed. (There are some exceptions)

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Ways to pay for taxes on dividends in a taxable account

Now that we have discussed the different tax rates and situations, we need to identify ways to pay these taxes that are owed from dividend income. Remember, even if you reinvest the dividends, the IRS will still expect payment of taxes for that income.

Regular Income

1. Pay the dividend tax out of your regular income.  This is the easiest method.  When you file your tax returns, you will include the dividend income from your 1099-DIV statement and this will add the appropriate tax amount to your regular return.  Any taxes withheld during the year from your paycheck will go towards paying the dividend taxes as well.  If you do not have enough withheld each paycheck, you may owe money at tax time.  As your dividend income gets larger, this may be tougher to do as your employer will not know to hold back enough taxes to cover.  You may have to pay out of pocket for some dividend taxes. You can avoid this surprise by requesting your employer to withhold additional money each paycheck to cover the added taxes.

Selling Shares

2. Sell shares to cover the dividend taxes.  The IRS doesn’t automatically withhold taxes when you receive your dividends.  The full dividend is credited to your account and you can use the funds to buy more shares or have it automatically reinvested.  Once you know what your tax liability is, you can sell a portion of your shares to cover the cost of the taxes.  For instance, if you had $10,000 in qualified dividend income, your taxes on those dividends would be approximately $1,500 for the year.  You could sell $1,500 worth of your investments to cover the tax costs. This in itself would be a taxable event so you would have to keep that in mind too.

Save a Portion of Dividends

3. Keep a portion of each dividend for tax purposes.  In this scenario, you would not automatically reinvest all your dividend income into new shares, but keep an appropriate portion of those dividends in cash to pay for the taxes at the end of the year.  For instance, reinvest 85% of the dividend amount received and keep the 15% in cash to pay the tax.

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Conclusion

Hopefully this helps in determining the tax requirements for dividend investing.  Paying taxes is part of the process when investing for dividends in a taxable account so you need to plan for it.  The benefit of investing for dividends in a taxable account is the flexibility to use that income when you need it, without having to wait until you are in retirement.  If you want to use the dividends when you are 40, 50, or 55 years old, you need to be able to access them.   Your only other choice is a taxable account.  Retirement accounts have limitations and penalties for using the dividends early. 

Remember that this is not tax advice, I am not a tax advisor.  This is for informational purposes only.  Consult a tax advisor for your personal situation.