Dividends are payments that some companies make to shareholders to reward them for investing in them. Dividends can provide regular, predictable income to investors who also preserve the chance of profiting from price appreciation. Dividends can qualify for advantageous capital gains tax treatment if stocks are owned long enough. Avoiding all income taxes on dividends is more complicated. Options include owning dividend-paying stocks in a tax-advantaged retirement account or 529 plan. You can also avoid paying capital gains tax altogether on certain dividend-paying stocks if your income is low enough. A financial advisor can help you employ dividend investing in your portfolio.
Dividend Basics
Dividends are payments investors get from owning shares of some companies. Companies that are profitable may distribute some of their profits as cash payments or stock dividends as a way to reward shareholders for investing in the business.
Dividend-paying stocks are popular alternatives to bonds for investors who want to generate passive income. Retirees often invest in dividends so they can pay their living expenses without having to sell stocks.
Like all income, dividends are subject to taxes. The tax rates depend on whether dividends are considered qualified or non-qualified. Ordinary or non-qualified dividends are paid by stocks that are owned for less than the required holding period. These dividends are taxed at an investor’s ordinary income tax rate. Qualified dividends, which are paid by stocks that are owned for at least the required holding period, are taxed as capital gains.
Capital gains rates are generally lower than ordinary income rates and range from 0% to 20%. Rates are based on the taxpayer’s income and most taxpayers are in the 15% capital gains bracket. As an example, an investor who earned $10,000 from qualified dividends typically would owe capital gains taxes of $1,500, reducing their after-tax gain to $8,500.
How to Avoid Taxes on Dividends
There are a few strategies for avoiding taxes on your dividends, depending on whether they’re qualified or ordinary dividends:
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Roth retirement accounts. A Roth IRA is funded with after-tax money. Once a person reaches age 59 ½, money can be withdrawn tax-free. So any dividends paid out by stocks owned in a Roth account would be free of taxes, as long as the dividends were withdrawn after age 59 ½ and at least five years after the account was opened.
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Qualifying for zero capital gains tax. Capital gains taxes are graduated, with higher-income investors paying higher rates. Investors in the lowest income bracket owe zero capital gains taxes. Brackets change annually. For example, a married couple filing jointly with 2023 taxable income of $89,250 or less would pay no capital gains tax on dividends. Strategies such as contributions to retirement accounts and health savings accounts (HSAs) may reduce your income below the zero-capital gains tax threshold. As a result, you wouldn’t owe any taxes on qualified dividends.
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Education plans. Tax-advantaged 529 plans allow tax-free growth and withdrawals as long as the money is used to pay qualifying education expenses. So placing funds into a 529 plan and using the money to buy dividend-paying stocks will allow you to accumulate funds tax-free and also withdraw the money without owing taxes. However, this only works if the withdrawal amounts go for qualified education expenses such as tuition and books.
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Other retirement accounts. Other retirement accounts, like traditional IRAs and 401(k)s can offer partial relief from income taxes. These accounts are funded with pre-tax money. An investor can deduct money contributed to a traditional account from their current taxable income. But unlike Roth accounts, withdrawals are taxed as ordinary income. Holding dividend-paying stocks in a traditional IRA or 401(k) won’t eliminate your tax liability, but it could reduce it.
Bottom Line
Investing in dividend-paying stocks can generate income while also preserving the potential for capital appreciation. Dividend income may be taxed at capital gains rates that are lower than tax rates on ordinary income as long as the shares are held for at least a year. You may be able to avoid all income taxes on dividends if your income is low enough to qualify for zero capital gains if you invest in a Roth retirement account or buy dividend stocks in a tax-advantaged education account.
Investing Tips
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Consider checking with a financial advisor for suggestions about tax-efficient ways to generate income through dividend investing. SmartAsset’s free tool matches you with up to three vetted financial advisors in your area, and you can interview your advisor matches at no cost 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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To plan well for your financial future, you need to have some idea of how much your investments will be worth in the future. SmartAsset’s Investment Return & Growth Calculator can help you estimate how much your portfolio could be worth. Provide the amount of money you’re starting with, the additional contributions you plan to make, your expected rate of return and how long you want to let the money grow. The calculator will then give you the future estimated value of your portfolio.
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The post How Do I Avoid Paying Tax on Dividends? appeared first on SmartAsset Blog.
Source: finance.yahoo.com