Why Do Taxes Matter?
I know taxes aren’t a popular subject, but they really should be. Not because I think they make great dinner conversation, but because they’re a fact of life, and far too many people are ignorant or misinformed about them.
If you plan on being wealthy, you need to develop a good offense and learn how to maximize your income.
Second to that, you need to develop a good defense, and learn how to keep as much of that income as possible. Your accumulated and retained income is what makes you wealthy, not the number of zeros on a check. There’s a huge difference between a high income and a high net worth.
Part of playing a good financial defense is minimizing your personal expenditures, and you can find a lot of good advice on how to do that from a variety of different sources. What people often lack, however, is a good understanding of how to minimize one of the biggest expenses you’ll face over the course of your life.
If you’re looking to minimize your tax bill, there are a few different ways you can do it, including avoiding earned income at all cost, which I don’t recommend.
Unfortunately, the US tax code is complex enough that it would take a long time to go over every way you can earn tax-advantaged income. For our purposes, we’re going to focus on the tax advantages provided to you should you decide to invest in dividend paying stocks from US corporations.
Why Dividends Will Decrease Your Tax Bill
Well, here’s the thing.
Technically speaking, unless you put your money in a tax-exempt investment like municipal bonds, you’re going to have to pay taxes on your income.
That said, if you’re going to put your money into an investment, would you rather do it in investment that has a relatively high tax rate, or a relatively low one? If you’re passingly familiar with math, you’d probably prefer the low tax rate investment, since that means you’re going to be keeping more money after paying Uncle Sam.
Which is where dividends come in.
Over time, Congress has decided that there are certain activities that they would like to encourage from you and I, the taxpayers. One of those activities is investing our money in US corporations through brokerage accounts, retirement accounts, and the like.
To encourage you to invest in US companies, they’ve decided to tax income from these activities at lower tax rates, provided you meet certain criteria such as length of ownership, type of asset, and the type of company you own. As a whole, the income from these activities is known as preferentially taxed income.
Which is why dividend paying companies can be a good way to decrease your tax bill relative to what it would have been had you invested in something else. Because qualified dividends are taxed using the capital gains tax rates, you save money compared to what you would have earned if you had received that income from your job or through rental income generated by your real estate.
(As a side note, although rental income is taxed at ordinary tax rates, there are several ways you can, and should, decrease your tax bill if you invest in real estate).
What Are Qualified Dividends?
By now you’ve heard me say qualified dividend at least once, and that they are taxed at preferential rates.
But what exactly are qualified dividends?
Great question. The IRS defines qualified dividends as “the ordinary dividends subject to the same 0%, 15%, or 20% maximum tax rate that applies to net capital gain.”
In English, qualified dividends are dividends you receive from a company that are paid out of the earnings and profits of that company, and that the IRS has decided can be taxed at lower tax rates.
To be taxed at those rates, the dividend must meet three requirements.
First, the dividend must be paid by a US corporation or a qualifying foreign corporation.
Second, the dividend cannot be listed under the IRS’ list of not qualified dividends.
Third, you have to have owned the stock that paid the dividend for more than 60 days during a 121-day period around the company’s ex-dividend date. Essentially, if the company’s ex-dividend date is April 29 2017, you must have owned the stock for 60 days sometime between February 26 2017 and June 27 2017. The day you buy the stock doesn’t count, but the day you sell it does.
The IRS has created a few exceptions to these rules, but they’re more than I want to talk about right now. (You’re free to contact me if you want more information, and I’ll send you in the right direction).
To summarize, let’s compare two scenarios.
Let’s say you’re married, file jointly on your taxes, and make $65,000 a year, using the 2017 tax tables. You want to increase your income, so you’ve invested in dividend paying stocks and were paid an extra $15,000 in qualified dividends. That income would be taxed at 15% and you would owe taxes of $2,250, without factoring in deductions, exemptions, or exclusions.
If, instead of earning dividends, you were paid an extra $15,000 from your job, that income would push you into the next highest tax bracket, meaning that you would pay an extra $2,660 in taxes, so you would owe $410 more in taxes than you would if you had received the money in dividends.
Sure, $410 isn’t a huge amount, but the effect is compounded the higher your income goes and depending on your filing status. (For someone filing single, the difference from this scenario would be $1500 in taxes).
What Are Ordinary Dividends?
Alright, so we’ve covered qualified dividends and given a brief explanation of why they can save you on your taxes, but what about ordinary dividends?
Ordinary dividends are dividends that are not qualified dividends, which is a terrible explanation, so you should just think of it as everything else.
Examples of these include capital gain distributions, dividends paid on deposits with most banks, credit unions, and similar financial institutions. They also include dividends from tax-exempt organizations, foreign corporations, or payments in lieu of dividends.
The main thing you need to understand about ordinary dividends is that they are taxed at the same tax rates as your wages and payroll, so you miss out on any tax savings you would have received from a qualified dividend.
Keep that in mind when deciding which companies to buy stock in, or when to sell stock if you’re within the holding period window around a company’s ex-dividend date. Also, if you’re an investor that likes to invest in REITs, you should know that on average, REIT income is also taxed at your ordinary tax rate.
Hopefully, this will help you understand some of the tax advantages of dividend income. Please keep in mind that there are some cases where this advice will not apply, and I am not a registered financial advisor, so if you have complex questions it would be best to consult with one, or with a CPA.
I’d recommend the CPA.