Qualified Dividends and Capital Gain Tax Explained
Both dividend income and capital gains are sources of profit for a shareholder and will create possible tax liabilities for investors. Capital is the initial sum that is invested. A capital gain is the profit that happens when an investment is sold for a higher price than the original purchase price. An investor won’t make any capital gains until they sell the investments and make a profit. Dividend income is paid out of the profits a corporation makes to the stockholders. It is considered income for the tax year instead of a capital gain. However, qualified dividends are taxed as capital gains instead of income. Since there is a lot of confusion about capital gains tax, a tax manager can help you with this part of your taxes and with general tax tips.
What Are Qualified Dividends and Capital Gain Tax?
Even though both dividend income and capital gains are different, the U.S. tax code gives similar treatment to both dividends and short-term capital gains. as well as long-term capital gains and qualified dividends. Taxes are taken out on both capital gains and dividend income but it’s not the same as income tax. In order to figure out how to calculate this tax, it’s best to use the qualified dividend and capital gain tax worksheet.
What Is the Qualified Dividend and Capital Gain Tax Worksheet?
Figuring out the tax on your qualified dividends can be difficult for even the most experienced accountant. There are tax codes to adhere to, numbers to crunch, and definitions to memorize. However, the process can be relatively straightforward if you use the dividend and capital gain tax worksheet that is provided by the IRS.
How Is the Qualified Dividends and Capital Gain Tax Worksheet Used?
In order to use the qualified dividends and capital gain tax worksheet, you will need to separate your ordinary dividends from qualified dividends. Ordinary dividends are going to be treated as ordinary income. Any dividend you receive on preferred or common stock is going to be considered an ordinary dividend unless you are told something different by the issuing corporation.
The qualified dividends and capital gain tax worksheet can be separated into different lines in order to make it easier for you. Lines 1-7 are for ordinary income and qualified income. Lines 8-11 are for non-taxable qualified income. Lines 12-14 are for qualified taxable income. Lines 15-19 are for the 15% bracket qualified income. Lines 19-23 are for qualified tax. Line 24 is for income tax. There is no worksheet for calculating your income tax owed. Lines 25-27 are for total tax. This will almost always be your tax.
Click here to access the worksheet
What are Qualified Dividends?
One main distinction when it comes to taxes is whether or not a dividend is qualified. A qualified dividend will be one that falls under capital gains tax rates and is then taxed at a lower rate than income taxes rates for those that are unqualified or ordinary. The difference between the two means that the tax rate can be substantial.
Requirements for Qualified Dividends
There are some requirements in order to help you know if your dividends are qualified.
Qualifying Foreign Companies: A foreign corporation can qualify for this special tax treatment if it meets one of a list of conditions. It must be incorporated in a U.S. possession, the corporation is eligible for benefits of a comprehensive income tax treatment with the U.S., or the stock is tradable on an established securities market in the country. A foreign corporation will be qualified if it is considered to be a passive foreign investment company.
Dividends That Won’t Qualify: There are some dividends that are going to be automatically exempt from consideration as qualified. These include dividends that are paid by real estate investment trusts, those on employee stock options, and those for tax-exempt companies. Dividends that are paid from a money market account, such as credit union, savings bank, or another financial institution, don’t qualify and instead should be reported as interest income. If it is a special one-time dividend, it is also not qualified. Qualified dividends need to come from shares that aren’t used for short sales or associated with hedging.
Holding Period: In order to benefit from the tax rate on qualified dividends, the IRS says that as the investor you hold shares for a minimum period of time. Investments must be held for over 60 days during a 121-day period that starts 60 days before the ex-dividend date for common stock investors. If you are holding a preferred stock then the holding period is more than 90 days during the 181-day period that begins 90 days before the ex-dividend day. For mutual funds, the holding period requirements will be different. A mutual fund must have been held unhedged for at least 61 days of a certain period. Investors also need to hold the applicable share of the mutual fund for that same period.
A regular dividend will be classified as either ordinary or qualified. In order to be considered qualified, the dividend will need to meet requirements that are set forth by the IRS. Unqualified and qualified dividends may have differences, which seem minor but actually have a big impact on overall returns.
Typically, most regular dividends distributed by a U.S. company are qualified. One of the biggest differences between the two types of dividends is how they are taxed.
For many everyday investors, understanding if a dividend will be qualified isn’t usually an issue. Most regular dividends that come from a United States corporation will be considered qualified. If an investor is focused on foreign companies then it becomes important to consider the requirements.
There isn’t much an investor can do in order to have a say in whether or not a dividend will be considered qualified. As an investor, one of the most important things you can do is to hold stocks for the minimum holding period in order to make sure they are qualified.
Qualified dividends are included in your adjusted gross income. However, keep in mind that a qualified dividend will be taxed at a lower rate than an ordinary dividend.
The reason to distinguish between ordinary and qualified dividends is how the stock is going to be taxed. Ordinary dividends are going to be taxed at an ordinary income tax rate. Whatever your bracket is, will be the rate you are going to pay. Ordinary dividends may sometimes be called unqualified or nonqualified dividends. Ordinary dividends are going to be the most common type of distribution from a mutual fund or corporation.
Interest income and short-term capital gains are usually treated as normal income. Knowing this can help you pick which investments make the most sense for you.
The IRS considers most dividends to be taxable income. Regardless of the amount of dividend payments, you will need to report them on your tax return. Usually, if you receive dividends of $10 or more in a tax year then you receive a Form 1099-DIV from your financial institution. This form reports the capital gains distributions, non-dividend distributions, dividends, and the amount of tax, if any was withheld from payments during the year. Even if you don’t receive this form, you should still report your dividends on your tax return. There are different forms you may need to use to report your dividends. The Schedule B form titled “Interest and Ordinary Dividends” is used to report your interest and dividend earnings if the total is more than $1,500. This form is for each financial institution you got dividends from and the amount from each 1099-DIV form you get. Part 1 is going to be used for any bank interest and Part 2 is going to be used for your dividend payments. Part 3 may be needed depending on how much interest you have in a foreign financial account or trust.
How Do You Avoid Paying Tax on Dividends?
When you are getting money, you want to do your best to avoid paying taxes on that money. While you may be able to find a clever accountant who can work this out, paying taxes is going to be a reality when it comes to dividends. Remember that dividends do qualify for a lower tax rate as long as they are qualified. However, there are some legal ways you may be able to avoid paying taxes. Also reference the section below on how to avoid and minimize the capital gains tax for more information.
Don’t Make Too Much Money: If you are in a lower tax bracket then you may qualify for a lower tax rate on dividends.
Use a Tax Shielded Account: If you don’t want to pay taxes on dividends then use a Roth IRA. You are contributing already-taxed money to your Roth IRA. You won’t have to pay taxes as long as you are taking out the money in accordance with set rules. If you have investments that generate a large dividend then you may want to consider putting them in a Roth account. If money is going to be used for education then you may also want to invest it in a 529 college savings plan. Using a 529, when dividends are paid it means you don’t pay any tax either. You would have to use the money to pay for education or you will face a fee.
Finding an exchange-traded fund that reinvests dividends may seem like a way to solve the tax issue but this actually won’t work. Taxes will still be due on dividends, even if the proceeds are reinvested.
What are Capital Gains?
The easiest way to explain a capital gain is by taking the selling price and subtracting the purchase price. Not every capital asset is going to qualify you for a capital gains treatment. This includes depreciable business property and business inventory.
Long Term vs. Short Term Capital Gains
The taxes you pay on capital gains is going to depend on how long you have held the asset before you sell it. In order to qualify for a more favorable tax rate, you must hold the asset for more than one year. If you have held the asset for less than a year then you are taxed at the ordinary and higher income tax rate.
How Can You Avoid or Minimize Capital Gains Tax?
There can be things you can do in order to avoid or minimize the capital gain tax you pay.
Invest in the Long Term: If you find great companies and can hold the stock for the long term then you are gong to pay the lowest rate of tax. This can be easier to do in theory since a company’s fortunes can easily change over the years. There are a number of reasons why you may need or want to sell earlier than you planned.
If you are investing your money through retirement plans then it grows without being subject to taxes right away. You are also able to sell and buy investments without the retirement account and not trigger a capital gains tax. If you are using traditional retirement accounts then gains are going to be taxed as ordinary income when you go to withdraw the money.
However, you may be in a lower tax bracket at this stage than when you were on the job with full-time income. With a Roth account, the money you withdraw is going to be tax-free as long as you are following the requirements for withdrawals. For an investment that is not part of a retirement account, it may make more sense to wait until you are done working to sell the investment. If your retirement income is low enough then your tax bill could be reduced or you could avoid paying the tax altogether.
If you do have an investment loss then you are able to take advantage of this and decrease the tax on your gains or your other investments. If you sold both the losing stock and another one then the loss on one would reduce the tax you owe on the other. In a perfect world, all your investments would appreciate, but losses can happen so you can take advantage of them. Note that only short-term losses can be used to help offset your short-term gains. Long-term losses can help offset the long-term gains.
If you are selling something you bought about a year ago then you need to be mindful of the trade date. Wait a few days or weeks in order to qualify for the long-term capital gains treatment in order to minimize payments.
When you have gotten shares in the same mutual fund or company at different times and at different prices then you need to look at your cost basis for the shares you sell. Many investors will usually use the first in, first out approach to calculate cost basis, but there are other ways to calculate. If you are going to sell a sustained holding then you may want to work with a tax advisors in order to determine the method that makes the most sense for you.
Final Thoughts: Are Capital Gains or Dividends Better?
There really isn’t an answer on whether or not capital gains or dividends are better but it depends on what your goals are.
Dividends can be better when you have to live off your investments. However, capital gains can be a better option for building wealth.
There are some advantages of one over the other at certain times. Your own investing goals will guide you as to whether or not capital gains or dividends are gong to be better for you at any given time.
Dividends will allow you to live off investments. Companies that pay dividends are usually older and more established companies. Faster growing and younger companies need to invest profits back into the same company in order to continue growing and expand. If your personal wealth plan means you haven’t reached a level of invested net worth yet where you can live on your investments comfortably then it makes more sense to focus on capital gains. There will be no right answer for everyone and it’s going to be based on your own interest. Keep in mind that both capital gains and dividends are different types of investments but do get similar treatment when it comes to taxes.
Capital gains and dividends can be useful for long-term financial goals and wealth. Both are taxed but not as much as your regular income. It’s important to make the distinction between qualified and non-qualified dividends in order to determine how much in taxes you will pay. The qualified dividends and capital gain tax worksheet can be helpful when you are filing your taxes and you have to pay this tax.
