The basics

Dividends

A cash dividend is income received from an equity investment, including common and preferred stock. Investors can also receive dividends from packaged products (e.g., mutual funds, closed-end funds, ETFs) that pass through income earned by the investments in their portfolios.

Qualified dividends (covered below) are taxed at lower rates than many other forms of investment income (e.g., bond interest). The rate an investor pays depends on their annual taxable income, which can include all of the following:

• Salary
• Wages
• Commissions
• Bonuses
• Royalties

Dividends can be qualified or non-qualified, which determines how they’re taxed. In general, as income increases, the tax rate increases. This is a progressive tax structure (discussed below). Qualified dividends are taxed at lower rates than non-qualified dividends. Here’s the basic breakdown:

Qualified dividend tax rates

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

Test questions about tax brackets are often generalized because brackets change over time. Still, here’s a reference table for investors filing single and married filing jointly (tax year 2026):

Tax Rate	Individuals	Married filing jointly
0%	$0 - $48,350	$0 - $96,700
15%	$48,350 - $533,400	$96,700 - $600,050
20%	$533,400+	$600,050+

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 insurance or a 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 unusual and unlikely to be tested (it’s usually enough to know that a holding period requirement exists for a dividend to be qualified). 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 see a question about qualified dividend tax rates that doesn’t specify the investor’s income level. If that happens, assume a 15% rate on qualified dividends.

If a dividend is not qualified, it’s taxed as a non-qualified (ordinary) dividend. The applicable tax rate equals the investor’s federal marginal income tax bracket, which is the rate applied to the last dollar earned. As of tax year 2026, these are the income tax brackets for individuals and those filing jointly:

Rate	Individuals	Married filing jointly
10%	$0	$0
12%	$11,926	$23,851
22%	$48,476	$96,951
24%	$103,351	$206,701
32%	$197,301	$394,601
35%	$250,526	$501,051
37%	$626,351	$751,601

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 $11,925 earned, a 12% tax on additional income up to $48,475, 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 for 2026, assume a person making $50,000 is in the 22% marginal tax bracket. They will pay $1192.50 on the first $11,925 earned ($11,925 x 10% tax rate), $4,386 on income between $11,926 and $48,476 ($36,550 x 12% tax rate), and $335.28 on income between $48,476 up to $50,000 ($1,524 x 22% tax rate). Together, the total tax is $5,913.78, representing an effective tax rate of 11.8%.*

*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 generally create a lower tax obligation.

For example, assume an individual with an annual salary of $50,000 receives a $100 dividend:

• If the dividend is qualified, the tax rate is 15% (from the qualified dividend table above), so the tax is $15 ($100 x 15%).
• If the dividend is non-qualified, the tax rate is 22% (from the marginal income tax bracket table above), so the tax is $22 ($100 x 22%).

In most exam scenarios, you can assume common stocks, preferred stocks, and mutual funds pay qualified dividends unless the question says otherwise. However, one dividend-paying investment never pays qualified dividends: real estate investment trust (REIT) dividends are always considered non-qualified (taxable up to 37%). Because REIT dividends can be taxed at higher rates, REITs generally need to offer higher returns to attract investors.

Sidenote

Mutual fund dividends

As discussed above, you can usually assume a mutual fund distributes qualified dividends unless the question specifies otherwise. If a question goes deeper, the key idea is that a mutual fund’s dividend treatment depends on the underlying income it passes through.

To determine whether a mutual fund dividend is qualified, the requirements listed above are applied to the underlying securities in the fund. For example, assume a value fund holds only common stock. For a dividend paid by the fund to be qualified, the underlying dividends must come from US or qualified foreign corporations, and the fund must meet the IRS holding period requirement. If those conditions are met, the dividend paid to the fund’s shareholders is 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, the interest would be taxed at a 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 resident of the municipality. 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 annually on tax form 1099-DIV. Brokerage firms send these forms to their customers and to the IRS. The form shows the dividends received and whether they were qualified or non-qualified.

To appear on a given year’s 1099-DIV, the dividend must be paid in that year. For example, if a dividend is declared in 2025 but paid in 2026, it’s reported on the 2026 1099-DIV.

Cash dividends are taxable, but stock dividends and splits are not. With a stock dividend or split, the investor receives more shares, but the share price adjusts proportionately, so the overall value of the position doesn’t change. The new shares received are not taxable until they’re sold.

Sidenote

Progressive vs. regressive taxes

The United States currently uses a progressive tax system for income taxes: higher income generally means a higher percentage of income paid in taxes. The lowest federal income tax bracket is 10% (for low reported income), while the highest income tax bracket is 37% (for high reported income).

Estate and gift taxes are also progressive. An estate refers to assets owned by a deceased person that are eventually distributed to heirs and beneficiaries. For tax year 2026, the federal government only taxes estates valued above $15 million, while taxes are only due on gifts valued above $19,000. In a progressive system, smaller amounts are taxed at lower rates (or not taxed at all).

A regressive tax system applies the same rate regardless of income level or the amount of money involved. Sales tax is a common example. Whether you’re a billionaire or have no reported income, you pay the same percentage tax on items you buy at the store. Excise tax (a tax on a specific good, like cigarettes) is also regressive.

Interest

Interest is income from a debt instrument (like a bond). When a debt security is purchased in the primary market, the investor lends money to an organization in return for interest. Interest generally isn’t taxed as favorably as dividends. However, depending on the issuer, some 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

Mortgage-backed securities

• Subject to federal, state, and local taxes

Municipal debt

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

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 (shown in the chart above). Interest is taxed the same way as non-qualified dividends.

Sidenote

Accrued interest

We discussed accrued interest in a previous chapter. Accrued interest paid by the buyer is deducted against interest received from the issuer.

For example, assume an investor purchases a $1,000 par bond at par and also pays $30 of accrued interest to the seller. Later in the year, the investor receives $100 of interest from the bond issuer. The investor would report a $1,000 cost basis (discussed below) and $70 of net interest.

Capital gains & losses

A capital gain is realized when a customer sells a security for more than its original cost. The phrase “buy low, sell high” refers to capital gains. Selling a security for less than its cost creates a capital loss.

A gain or loss is realized when the position is closed out (long securities are sold or short securities are repurchased). To determine the gain or loss, investors compare cost basis to sales proceeds.

• Cost basis is the total amount paid to buy the security, including transaction fees (e.g., commissions).
• Sales proceeds is the total amount received when selling the security, minus transaction fees.

To see how this works, walk through this example:

An investor purchases shares of ABC stock at $50 while paying a $2 per share commission. Several months later, the stock is sold for $70 while paying another $2 per share commission. What is the cost basis, sales proceeds, and capital gain or loss?

Can you figure it out?

Capital gains can be long-term or short-term.

Long-term capital gains are made on securities held for over a year. Technically, an investor must hold an investment for one year and a day to obtain long-term status. Long-term capital gains are taxed similarly to qualified dividends - 0%, 15%, or 20% - depending on annual income.

Sidenote

Vague test questions, part II

You may see a question about long-term capital gain tax rates that doesn’t specify the investor’s income level. If that happens, assume a 15% rate on long-term capital gains.

Bottom line: assume a 15% tax rate on qualified dividends or long-term capital gains unless the question indicates otherwise.

Short-term capital gains are made on securities held for one year or less. Short-term capital gains are taxed at the investor’s income tax bracket, which can be as high as 37% (similar to non-qualified dividends). Investors generally prefer long-term capital gains because they’re taxed at lower rates.

Capital gains are reported on form 1099-B (B stands for brokerage proceeds). Each year, brokerage firms report their customers’ capital gains and losses to the IRS. If the investor has more gains than losses (a net capital gain), they owe taxes. A net capital loss can be used as a deduction.

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

Stock dividends and splits

• New shares received are not taxable until sold

Interest

• Potentially taxable income from debt securities
• Reported on tax form 1099-INT
• Tax rate equal to federal marginal income tax bracket (up to 37%)

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

Capital gain

• Securities sold for more than the basis
• Reported on tax form 1099-B

Capital loss

• Securities sold for less than the basis
• Reported on tax form 1099-B

Long-term capital gain

• Gain on security held more than 1 year
• Tax rate: 0%, 15%, or 20%

Short-term capital gain

• Gain on security held for 1 year or less
• Tax rate: up to 37% (income tax bracket)

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