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Investing in dividend-paying companies is one of the simplest ways to earn an extra stream of income. Here, investors will benefit from a stable stream of recurring dividend income as well as long-term capital gains. However, similar to most other income, dividends are not free money and is taxed by regulatory authorities.
Here are a few ways you can trim your tax bill by understanding how dividends are taxed.
Qualified dividends attract lower dividends
There are hundreds of dividend stocks that you can choose from. But investors should know not all dividends are taxed at the same rate.
Unlike ordinary dividends, a qualified dividend allows you to unlock the same rates as long-term capital gains. A dividend is considered as qualified if it is an ordinary dividend paid by a U.S. corporation or a qualified foreign entity whose shares are listed on a major exchange in the U.S.
With these dividends, investors will gain access to the 0%, 15% and 20% tax brackets instead of the usual federal income tax rates that could be as high as 37%.
A lower tax bracket is beneficial
Your total taxable income may qualify you for a lower tax rate on dividends. For example, in case you earn less than $40,400 each year as a single filer, or less than $80,800 as a married filer, you are eligible for the 0% tax-rate on qualified dividends.
In case you earn between $40,401 and $445,850 the dividends are taxed at a rate of 15%. For individuals earning annual income above $445,851 the dividends attract a 20% tax.
A tax-advantaged account like the IRA will lower dividend taxes
In case you own dividend-paying stocks in a taxable brokerage account, you will have to pay taxes on dividend payouts. However, you are allowed to defer or skip these taxes altogether by investing in an IRA or an Individual Retirement Account.
Traditional IRAs will not charge you taxes until you withdraw money from this account. Comparatively, Roth IRAs allow you to contribute money you have already paid taxes on and grow that money tax-free.
The final takeaway
Dividend stocks present an attractive opportunity for investors to earn additional income. In case you reinvest these dividends and buy additional shares, you will benefit from the power of compounding over time. You will also get the benefits of paying lower taxes on this income than you would from earning employment income.
So, in case you are planning to begin your investment journey by purchasing dividend stocks and grow your portfolio, these tax benefits can provide you with a great incentive.
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