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.
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.
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.
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.
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:
- Subject to federal taxes
- Exempt from state and local taxes
- Exempt from federal taxes
- Subject to state and local taxes
- 100% tax free for residents
- 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.