Tax on Dividends

William, rookie investor

Do you have to pay tax on dividends?

I've heard plenty about sheltering investments from tax, but how much can I shelter, is it a total shelter and do I pay tax at some point further down the line?

And above all else... is it legal?!



Well like so many things in life the answer is not that straightforward.

The answer only full response possible is "it depends".

It depends on where you live. Different countries have different tax rates for dividends.

It depends on your income. A high rate tax payer (in most countries) pays more tax on dividends than a low rate tax payer. It depends on how you hold your investments. Many countries have tax shelters (that are perfectly legal) where you can hold your investments and not pay any tax on the dividends or capital gains tax.

This article is only a very basic overview on tax on dividends. The real answers are very personal to you and you need to understand how the laws apply where you live.

Consult your financial advisor if you're not sure where you stand.

Mike - six-figure dividend earner

Double taxation - an argument against tax on dividends

When a corporation makes a profit, it will often have to pay corporation tax on those profits. The rate will depend on the jurisdiction where the profit is made.

If it uses its after tax profits to pay out dividends then the shareholder may have to pay tax on those dividends as well, meaning that the profit is taxed twice. Some countries, such as Australia, give the shareholder a credit (franking credit) when the corporation tax is paid so this double tax is avoided. This, however, is not the case in the United States. 

Dividend tax rates

If you are a US tax resident and your dividends are "qualified" then your federal tax rates on dividends will be nothing if your income is in the 10-15% tax brackets, the rate will be 15% if your income is in the 15%-39.6% tax bracket, and your rate will be 20% if you are in the 39.6% tax bracket.

You may also need to pay a 3.8% medicare surcharge and state taxes on top. Unqualified dividends are taxed at your ordinary income tax rate.

What are qualified dividends?

For your dividends to be qualified, which gives you more favorable tax treatment, they need to meet certain criteria. Firstly there is a holding period. You need to have held the (common) stock for more than 60 days during the 121 day period that starts 60 days before the ex-dividend date.

Also for the dividend to be qualified, the dividend must be paid by a US corporation or by a foreign corporation that trades on a major US exchange (including ADRs) or from a corporation incorporated in a possession of the United States.

For more information, please have a look at the IRS site at: www.irs.gov/publications/p17/ch08.html#en_US_2015_publink1000171584

Tax shelters

If you are eligible then you should look to use your tax shelters as much as possible.

These have different rules but essentially allow you to build up your dividends and capital gains tax free whilst they are in the account. Please see our page on tax advantaged accounts for more information.

Tax on dividends - state taxes:

You may have to pay state taxes as well as federal taxes. The rate depends on your income level and where you live. If you live in California (as of 2014), the top state rate is 13.3% where as in Alaska, Florida, Nevada, South Dakota, Texas, Washington or Wyoming there is zero state tax on dividends. The full list can be found at http://taxfoundation.org/article/united-states-high-tax-burden-personal-dividend-income

A final thought about tax generally

I often seem to meet people who seem obsessed by avoiding tax. Some people appear to be so determined not to pay tax that they are often blinded to opportunities.

What I would say is: Large tax bills are a good problem to have. It means you are earning a lot!

Don't be someone who would take $25,000 tax free over $50,000 pre-tax - unless your marginal rate is over 50% of course!

Naturally we are not advocating that you pay more tax than you have to. You should do all you can to minimise it legally by using up your tax shelters and relevant allowances. All I say is don't let the tax tail wag the investment dog. Selecting good investments is far more important than selecting lousy investments that are tax free. Trust me - I've learnt this the hard way!

Mike - six-figure dividend earner

Mike - six-figure dividend earner

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