Tax Implications of Dividends
Investors earn dividends from stocks, mutual funds and exchange traded funds--ETFs. Dividends are included in an investor's taxable income when income tax time comes around. The tax rate on dividends depends on how the distributions are classified. Some dividends qualify for a lower tax rate and others are taxed as ordinary income.
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History
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Historically, dividends received were taxed as ordinary income. The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the income tax rate on qualified dividends to 0, 5 or 15 percent, depending on the taxpayer's marginal income tax bracket. The reduced taxes on qualified dividends originally was in effect through 2008 and then it was extended until the end of 2010.
Identification
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Companies that pay qualified dividends are regular American corporations and qualified foreign corporations. Mutual funds and ETFs that receive qualified dividends will pass them through as tax-qualified distributions. The other requirement to pay the lower tax rate on dividend income is a holding period. The investor must have owned the shares for at least 60 days before the dividend record date for the dividends to qualify for the lower tax rates.
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Exceptions
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Non-qualified dividends come primarily from companies that are organized under a provision of the tax code that reduces their corporate income tax bills if they pay most of the earnings out as dividends. Some types of corporations that pay non-qualified dividends are real estate investment trusts--REITs--and master limited partnerships--MLP. These types of stocks tend to be high-yield dividend payers because of the corporate structure. Investors need to be aware that they will pay a higher income tax rate on non-qualified dividends.
Significance
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For many investors, dividends are a significant portion of their total investment return. It is important to know how much income taxes will reduce the earnings from dividends. For stock investors, if the company has the words trust or partnership in the name, check out the status of the company's dividends.These types of corporations usually have information about the taxation of dividends on the investor information page of their website. Mutual funds pass through income and dividends received as fund dividends. A stock fund may pay qualified dividends based on the stocks in the fund. Bond funds will pay non-qualified dividends for income tax purposes.
Considerations
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The companies that pay you dividends will send an IRS form 1099-DIV at the end of the year with the amount of dividends you were paid. The 1099-DIV has different boxes for listing the amount of qualified and non-qualified dividends. Under the tax laws in effect in 2010, the lower tax rate for stock dividends will expire at the end of 2010. In 2011, all dividends will be taxed at the investor's marginal tax rate.
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References
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