Dividends

Taxes are more than what you pay when you purchase groceries. When an investor makes money on an investment, the government taxes those returns. Varying levels of taxation exist depending on the security and transaction. Ultimately, taxes directly influence the overall return made by the investor.

In this unit, we’ll learn about different types of taxes, how they’re assessed, and how they influence investing. This chapter specifically covers dividends.

A cash dividend is income received from an equity investment, which includes common and preferred stock. Investors also receive dividends from packaged products (e.g. mutual funds, closed-end funds, ETFs) 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). The rate paid is determined by an investor’s annual taxable income, which includes all of the following forms of income:

• Salary
• Wages
• Commissions
• Bonuses
• Royalties

The more income one makes, the higher the investor’s tax rate. 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):

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 in the US (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.

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:

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. 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.