Dividend investors who focus on generating steady income need to focus on tax planning to maximize long-term returns. While dividend income is a reliable source of cash flow, taxes levied can significantly impair an investor’s net earnings.
The tax implications vary based on the income of the investor and if the dividends are qualified or non-qualified, with different investors being taxed at different rates.
For instance, an investor holding qualified shares of Apple bought during 2019 at $42/share, with less than $44,625 in annual income, would have received $6,275 in dividend income over five years, or $313/quarter, compared to less than $100/share per quarter for someone who bought the stock before the dividend being announced and at the highest tax bracket (37%).
Over a long enough horizon, investors can save hundreds of thousands of dollars in dividend income by optimizing their taxes. This article will go over the best approaches to minimizing taxes on dividends to maximize long-term returns.
Qualified vs Non-Qualified Dividends
It’s crucial for investors looking to maximize returns to understand the distinction between qualified and non-qualified dividends.
For instance, a dividend from a U.S. corporation held for more than 60 days within 121 days surrounding the ex-dividend date may be considered qualified and is taxed at a range of 0% to 20%.
On the other hand, dividends from certain foreign companies or those not meeting the holding period criteria are classified as non-qualified and are taxed at the individual income tax rate, which can be as high as 37%.
Taxes on dividends also vary based on income levels. Qualified dividends are taxed at 0% if an individual’s income is below $44,625 if single or Married Filing Separately, $59,750 if the person is Head of the Household, or $89,250 if Married and Filing Jointly. Investors above the threshold pay 15% in taxes for qualified dividends. If the investor’s taxable income exceeds $276,925, then the qualified dividend rate increases to 20%.
For dividends to qualify for these preferential tax rates, they must be paid by a U.S. Corporation or a Qualified Foreign company, with the investor holding the underlying stock for more than 60 days during the 121-day window that begins 60 days before the ex-dividend date. Essentially, this is done to encourage long-term investment, offering a tax-efficient income to committed investors.
Utilizing Retirement Accounts for Tax-Deferred Growth
Investors can use tax-advantaged accounts like Individual Retirement Accounts (IRAs) and 401(k)s for holding dividend-paying investments, which can significantly amplify wealth over time through tax-deferred growth.
Taxable accounts are subject to annual rates, which can impact the overall return, especially if dividends are non-qualified and taxed at the higher ordinary income rates.
Investors focusing on minimizing taxes can use tax-differed accounts, such as Traditional IRAs, which are not taxed until withdrawal, which is typically during retirement when the investor may be in a lower tax bracket.
Roth IRAs offer an even more compelling benefit for dividend investors. Although contributions are made with after-tax dollars, both the investment growth and withdrawals during retirement are tax-free, including the dividends earned, which can be a powerful tool for maximizing retirement income. In 2024, the Roth IRA contribution limit is $7,000 for those under 50 and $8,000 for those 50 and older.
Tax-Loss Harvesting to Offset Capital Gains
Investors can use Tax-loss harvesting as a strategy to minimize the taxes on their dividends. Tax-loss harvesting involves selling investments at a loss to offset taxes on capital gains.
This is particularly useful for investors looking to reduce their taxable income by pairing the sale of underperforming stocks with the gains of successful investments. Investors can realize the capital gains from a dividend-paying stock and sell another investment at a loss to neutralize the tax impact of the gain.
For instance, if an investor held shares of Planet Lab from the date of its SPAC in 2021, which has declined, showing a loss of $8,500 and has a gain of $10,000 on shares of Microsoft bought in 2019. This investor can then sell the shares in PlanetLab realizing the $8,500 loss and apply it against the $10,000 gain in Apple, effectively reducing the taxable capital gains to $1,500.
One thing that investors should consider is the IRS’s wash-sale rule, which prohibits claiming a tax deduction for a security sold in a loss if a substantially identical security is purchased within 30 days before or after the sale. The IRS has introduced the rule to prevent taxpayers from abusing tax-loss harvesting to create artificial losses.
Estate Planning and Tax Implications for Dividend Investors
Estate planning is a crucial part of managing the tax implications of dividend income for investors, thereby ensuring that their investment strategy aligns with their legacy goals.
A critical strategy that can be taken up during estate planning is the step-up in basis rule, which adjusts the value of inherited assets to their market price at the time of the original owner’s death.
This adjustment can significantly reduce capital gains taxes on inherited dividend-paying stocks, as beneficiaries are taxed only on gains that occur after the inheritance rather than from the original purchase price.
Another solution is to incorporate trusts or charitable donations to optimize the tax efficiency of the stock portfolio. By transferring dividend-paying stocks into a trust, investors can potentially lower estate taxes and provide a structured income stream to beneficiaries.
Donating stocks to charity can offer tax deductions while supporting philanthropic causes, allowing investors to manage their taxable estate’s size and leverage dividend income for social impact.
The Best Approach to Save Taxes on Dividends
Dividend investors looking to optimize their portfolios for tax optimization need to understand taxation, leverage retirement accounts, employ tax-loss harvesting techniques, and incorporate estate planning strategies.
Investors must stay informed of tax laws and focus on tailoring these strategies to their unique circumstances, ensuring a robust, tax-efficient investment portfolio poised for long-term growth.
