The basics

Dividends

A cash dividend is income received from an equity investment, which includes common and preferred stock. Investors also can receive dividends from packaged products (e.g. mutual funds, closed-end funds, ETFs) that pass through income received from investments in their portfolio. Qualified dividends (discussed below) are subject to lower tax rates than other forms of investment income (e.g., bond interest). The rate paid is determined by an investor’s annual taxable income, which includes all of the following:

• Salary
• Wages
• Commissions
• Bonuses
• Royalties

Dividends can be qualified or non-qualified, which relates to how they’re taxed. The more income one earns, the higher the investor’s tax rate. This is known as a type of progressive tax (discussed below). 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 bizarre and 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. In case you encounter a test question that dives deeper, let’s explore the tax treatment of mutual fund dividends.

To determine if a mutual fund dividend is qualified, the requirements listed above are checked against the underlying securities in the mutual fund. For example, let’s assume we’re discussing a value fund with only common stock in the portfolio. For a dividend paid to investors out of the fund 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 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 on the tax form 1099-DIV annually. Brokerage firms send these forms to their customers and the IRS. The form details dividends received and their status (qualified or non-qualified). For a dividend to show up on a given year’s 1099-DIV form, it must be paid in that year. If a dividend were declared in 2023 but was paid in 2024, it would be reported on 2024’s 1099-DIV form.

Cash dividends are taxable, but stock dividends and splits are not. Although the investor receives more shares with a stock dividend or split, their shares drop proportionately in value, resulting in no change in the overall value of the investment. The new shares received are not taxable until they’re sold.

Sidenote

Progressive vs. regressive taxes

Currently, the United States enforces a progressive tax system with income taxes; those with higher levels of income 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 $12.92 million, while taxes are only due on gifts valued above $17,000. Those with less money involved pay less or no taxes in a progressive tax system.

If your exam is in 2024, you may encounter updated test questions. Starting in 2024, the estate tax exemption increases to $13.61 million and the gift tax exemption increases to $18,000. Achievable’s test bank will be updated with the new concepts just before January 1st, 2024.

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 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 isn’t taxed as favorably as dividends are. 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

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

Sidenote

Accrued interest

We discussed how debt security purchasers pay accrued interest to investors selling those securities 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 additionally 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 at a higher price than its original cost. The phrase “buy low, sell high” refers to capital gains. Otherwise, selling a security below its cost is a capital loss. A gain or loss is realized upon a position being closed out (long securities sold or short securities repurchased). Investors compare their cost basis to sales proceeds to determine the overall gain or loss.

Cost basis represents the overall amount paid to buy the security, including transaction fees (e.g., commissions). Sales proceeds represents the overall amount received to sell a security, minus transaction fees. Essentially, cost basis represents the overall amount paid for an investment, while sales proceeds represent the overall amount received for selling it. To better understand this concept, let’s work through an 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 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 their annual income level.

Sidenote

Vague test questions, part II

You may encounter a test question regarding long-term capital gain tax rates that does not specify the specific tax rate or indicate the investor’s annual income level. You should assume a 15% rate on long-term capital gains if this occurs.

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 could be as high as 37% (similar to non-qualified dividends). Investors 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). Every year, brokerage firms report their customers’ capital gains and losses to the IRS. If the investor has more gains than losses (net capital gain), they will 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