Textbook
1. Introduction
2. Investment vehicle characteristics
3. Recommendations & strategies
3.1 Type of client
3.2 Client profile
3.3 Strategies, styles, & techniques
3.4 Capital market theory
3.5 Tax considerations
3.5.1 Dividends & interest
3.5.2 Capital gains & losses
3.5.3 Types of income
3.6 Retirement plans
3.7 Brokerage account types
3.8 Special accounts
3.9 Trading securities
3.10 Performance measures
4. Economic factors & business information
5. Laws & regulations
6. Wrapping up
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3.5.1 Dividends & interest
Achievable Series 65
3. Recommendations & strategies
3.5. Tax considerations

Dividends & interest

Much of the material discussed in this chapter will serve as a review of previous chapters. However, some new topics are covered, so we recommend you read the entire chapter.

It’s important to be aware of relevant tax considerations when investing. We’ll discuss the tax consequences of dividends and interest in this chapter.

Dividends

A cash dividend is income received from common or preferred stock. Investors also receive dividends from funds (e.g., mutual funds) that pass through income received from investments in their portfolio. Dividends are typically taxed at lower rates than other forms of investment income (e.g., bond interest, which is discussed below). The rate paid is determined by an investor’s annual income tax bracket, which includes all of the following:

  • Salary
  • Wages
  • Commissions
  • Bonuses
  • Royalties

The more income one makes, the higher the investor’s tax rate. This is known as a type of progressive tax (discussed further below). Dividends can be qualified or non-qualified, which relates to how they’re taxed. Qualified dividends are taxable at lower rates than non-qualified dividends (discussed below). Here’s a breakdown:

Qualified dividend tax rates

  • 0% (low income)
  • 15% (moderate income)
  • 20% (high income)

Test questions relating to tax brackets tend to be generalized as these brackets change annually. Regardless, here’s a table with the specifics for investors filing single and married filing jointly (for the tax year 2024):

Tax Rate Individuals Married filing jointly
0% $0 - $47,025 $0 - $94,055
15% $47,026 - $518,900 $94,056 - $583,750
20% $518,901+ $583,751+

Do not memorize the specifics; this chart is only for context.

For a cash dividend to be qualified, it must meet two general requirements imposed by the IRS:

  • Distributed by a US corporation or qualified foreign corporation*
  • The investor must meet a specific unhedged** holding period***

*To be considered a qualified foreign corporation, it must meet any one of the following requirements:

  • Incorporated in a US possession (including territories like Puerto Rico)
  • Subject to a US tax treaty
  • The dividend-paying security trades on an established stock exchange (e.g. an American Depositary Receipt trading on the NYSE)

**Unhedged means unprotected. An unhedged position does not have any insurance or another related product (e.g. a long put hedge) that would prevent the investor from experiencing a loss.

***The holding periods established by the IRS are a bit bizarre and are unlikely to be tested (knowing a holding period requirement exists for a dividend to be qualified should suffice). For example, the holding period for common stock dividends requires the stock to be held for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.

Sidenote
Vague test questions

You may encounter a test question regarding qualified dividend tax rates that does not specify the specific tax rate or give any indication of the investor’s annual income level. Assume a 15% rate on qualified dividends if this occurs.

If a dividend is not qualified, it will be taxed as a non-qualified (ordinary) dividend. The applicable tax rate equals the investor’s federal marginal income tax bracket, which represents the largest obligation for a taxpayer. As of the tax year 2024, these are the income tax brackets for individuals and those filing jointly:

Rate Individuals Married filing jointly
10% $0 $0
12% $11,601 $23,201
22% $47,151 $94,301
24% $100,526 $201,051
32% $191,951 $383,901
35% $243,726 $487,451
37% $609,351 $731,201

Do not memorize these tax brackets; this chart is only for context.

Definitions
Marginal tax bracket
The tax bracket applied to the last dollar earned

Example: an individual making $50,000 would pay a 10% tax on the first $11,600 earned, a 12% tax on additional income up to $47,150, and a 22% tax on the remaining income received. Although the investor is taxed at three different rates, they fall in the 22% tax bracket.

Effective tax rate
The overall tax rate paid on income

Example: continuing with the example above, let’s assume a person making $50,000 is in the 22% marginal tax bracket. They will pay $1,160 on the first $11,600 earned ($11,600 x 10% tax rate), $4,266 on income between $11,601 and $47,151 ($35,550 x 12% tax rate), and $627 on income between $47,151 up to $50,000 ($2,849 x 22% tax rate). Together, the total tax is $6,053, representing an effective tax rate of 12.1%.*

*The examples above assumes no tax deductions are taken.

The federal income tax rate an investor falls into determines the tax rate they pay on non-qualified dividends. Qualified dividends always result in a lower tax obligation. For example, let’s assume an individual making an annual salary of $50,000 receives a $100 dividend. If the dividend is qualified, they face a 15% tax rate (using the qualified dividend tax rate table above), resulting in a $15 tax obligation ($100 x 15%). If the dividend is non-qualified, they face a 22% tax rate (using the marginal income tax bracket table above), resulting in a $22 tax obligation. Obviously, investors prefer qualified dividends over non-qualified dividends.

In most scenarios on the exam, you can safely assume common stocks, preferred stocks, and mutual funds pay qualified dividends unless otherwise stated. However, one specific dividend-paying investment never pays qualified dividends. Real estate investment trust (REIT) dividends are always considered non-qualified (taxable up to 37%). With a higher income tax rate, REITs must offer higher rates of returns to encourage investors to purchase their units.

Sidenote
Mutual fund dividends

As discussed above, you can safely assume a mutual fund distributes qualified dividends to its shareholders unless otherwise specified. If you encounter a test question that dives deeper, let’s explore the tax treatment of mutual fund dividends.

The requirements listed above are checked against the underlying securities in the mutual fund to determine if a mutual fund dividend is qualified. For example, let’s assume we’re discussing a value fund with only common stock in the portfolio. For a dividend distribution to qualify, the disbursement must originate from the US or qualified foreign corporations, and the fund must meet the IRS-specified holding period. If so, the dividend paid to the fund’s shareholders will be considered qualified.

Dividends paid out of certain funds are always considered non-qualified. For example, dividends paid out of mutual funds holding US government and/or corporate debt securities. If an investor held these bonds directly, they would pay an income tax rate equal to their federal income tax bracket. The IRS treats the “pass-through” of this interest via a non-qualified mutual fund dividend* similarly.

*Income paid out of a mutual fund is always considered a dividend, regardless of the source income. For example, assume a bond fund receives interest from the bonds in its portfolio. When the interest is “passed through” to the fund’s shareholders, we call it a dividend.

Some dividend payments can be entirely tax-free (regardless of tax bracket). In particular, a municipal bond fund invests in debt securities that pay federally tax-free income. Additionally, the income could be entirely tax-free if the investor is a municipal resident. For example, an investor residing in California would receive tax-free dividends from the Putnam California Tax Exempt Income Fund* (Ticker: PCIYX).

*This fund invests primarily in California municipal bonds, which pay tax-exempt income to investors residing in California.

Dividends are reported on the tax form 1099-DIV annually, which brokerage firms create and send to their customers and the IRS. The form details the dividends received and the status (qualified or non-qualified). A dividend must be paid in that year to show up on a given year’s 1099-DIV form. If a dividend were declared in 2023 but paid in 2024, it would be reported on 2024’s 1099-DIV form.

Sidenote
Progressive vs. regressive taxes

Currently, the United States enforces a progressive tax system with income taxes; those with higher income levels pay a higher percentage of taxes on their income. The lowest federal income tax bracket is 10% (for those with low reported income), while the highest income tax bracket is 37% (for those with high reported income).

Estate and gift taxes are also progressive. An estate refers to assets owned by a deceased person, which eventually are distributed to heirs and beneficiaries. The federal government only taxes estates valued above $13.61 million, while taxes are only due on gifts valued above $18,000. Those with less money pay less or no taxes in a progressive tax system.

A regressive tax system is a flat taxing system, regardless of income levels or amount of money involved. Sales tax is an example of a regressive tax. Whether you’re a billionaire or have no reported income, you pay the same percent tax on the items you buy at the store. Excise tax, a tax on a specific good (like cigarette taxes), is also regressive.

Interest

Interest is income received from a debt instrument (like a bond). When a bond is purchased, the investor lends money to an organization in return for interest. Unlike dividends, interest isn’t taxed favorably. However, depending on the issuer, taxes may be avoided.

As a reminder, here’s the tax status of different types of bond issuers:

US Government debt

  • Subject to federal taxes
  • Exempt from state and local taxes

Municipal debt

  • Exempt from federal taxes
  • Subject to state and local taxes
  • 100% tax free for residents

Corporate debt

  • Subject to federal, state, and local taxes

If taxes are due, the applicable tax rate equals the investor’s federal marginal income tax bracket (displayed in the chart above). Interest is taxed the same as non-qualified dividends.

Key points

Cash dividends

  • Taxable income received from equity investments
  • Dividend-paying investments include:
    • Common stock
    • Preferred stock
    • Mutual funds
    • REITs
  • Reported on tax form 1099-DIV
  • Taxable in the year received

Qualified dividends

  • Tax rates
    • 0% (low income)
    • 15% (moderate income)
    • 20% (high income)
  • To be considered qualified:
    • Distributed by a US corporation or qualified foreign corporation
    • The investor must meet a specific unhedged holding period

Non-qualified dividends

  • Tax rate equal to federal marginal income tax bracket (up to 37%)
  • REITs pay non-qualified dividends

Progressive tax systems

  • Higher taxes if more money involved
  • Examples:
    • Income taxes
    • Estate taxes
    • Gift taxes

Regressive tax systems

  • Flat tax rates
  • Examples:
    • Sales taxes
    • Excise taxes

Interest

  • Potentially taxable income from debt securities
  • Reported on tax form 1099-INT

US Government debt tax status

  • Subject to federal taxes
  • Exempt from state and local taxes

Mortgage-backed securities tax status

  • Subject to federal, state, and local taxes

Municipal debt tax status

  • Exempt from federal taxes
  • Subject to state and local taxes
  • 100% tax-free if:
    • Resident
    • Territory bond

Corporate debt tax status

  • Subject to federal, state, and local taxes