If you hold a portfolio that contains stocks or equity funds, whether they are mutual funds or ETFs, then chances are you receive dividends. You probably reinvest at least a portion of them. But are reinvested dividends taxable?
Reinvested dividends are generally taxable like any other dividend but that doesn’t necessarily mean you’ll incur a tax liability. A few caveats will help you understand whether YOUR dividends are taxable, and how they are taxed if they are.
When you receive dividends in a portfolio a common practice is to simply reinvest those dividends. This is especially true when you are still saving and haven’t started taking distributions from your account.
This is often still true for a portion of your dividends in retirement, as you may not need to withdraw all of them. While dividends can be a key part of retirement income, there are some often-ignored risks of relying on dividends to provide the bulk of your income in retirement. For that reason, you may want to reinvest the dividends and consider a more comprehensive distribution strategy.
Reinvesting dividends is smart over the long-term as dividends are a key driver of long-term investment growth. Don’t make the mistake of thinking dividends are an “extra” return.
When you select investments within an investment account you’ll usually have the ability to select an option that allows you to reinvest the dividends. This sets up an automatic reinvestment so that you don’t have to go into your account and manually do it every time. You don’t even have to know that you received the dividends since it is automatic. When this arrangement is made directly with the issuer it is known as DRIP or dividend reinvestment plan.
Are Reinvested Dividends Taxable?
Yes. Even if you elect to have those dividends automatically reinvested, the receipt of dividends is a taxable event. However, there are two important items to consider. You may not owe any tax at all, and the amount you do owe depends on the type of dividend.
- Whether those dividends are received inside a tax-advantaged account such as an IRA or 401k. You won’t owe any taxes on dividends held in a retirement account until they are withdrawn. If you receive dividends in a Roth account, then you’ll never owe any tax on them as long as you follow the standard rules for Roth distributions. If you receive dividends in a taxable account, then you’ll incur a tax liability.
- Whether the dividends are qualified or unqualified. This distinction will tell you how the dividends are taxed.
If your dividends meet the criteria to become qualified dividends then you can avoid paying tax at your income tax rate. Instead your tax bill is based on the more favorable long-term capital gains rates of either 0%, 15%, or 20%.
So what is a qualified dividend?
Dividends must meet a few criteria in order to be qualified. IRS Pub 550 lists the criteria.
- The dividends must be from a US corporation or qualified foreign corporation.
- The Dividends are not specifically listed as unqualified. – the list is available in IRS Pub 550.
- You meet the holding period requirement by holding the stock for AT LEAST 60 days during the 121-day period that begins 60 days before the the ex-dividend date.
Most dividends that you receive will meet this criteria.
Dividends that do not meet the qualified dividend criteria are by default unqualified. You’ll incur a tax liability on these dividends at your ordinary (marginal) income tax rate.
Dividend Tax Planning
Since reinvested dividends are taxed, you can improve your own tax-efficiency with some careful planning.
If you plan ahead you may be able to avoid any unqualified dividends. This is obviously preferable in a brokerage account if you’ll have to pay the taxes, because that tax will be based on your marginal income tax rate.
Another idea altogether is to consider in which account you hold your dividend-producing stocks. The concept here is asset location.
If you receive dividends within a retirement account then you will eventually pay income tax on them anyway when you take them out. If you don’t plan to withdraw those dividends for many years then that’s probably fine. Holding them within the retirement account will shield them from taxes and reduce the tax drag on your portfolio. In other words, the long term growth could offset the fact that you’ll ultimately pay income tax on those dividends.
However, if you plan to spend those dividends pretty soon it likely makes more sense to hold the high dividend stocks in a taxable account. Why? You can significantly reduce your tax bill since qualified dividends are taxed at long term capital gains rates. If you plan to withdraw them right away then hold them in a taxable account. You can avoid the income taxation of a retirement account distribution, and take advantage of the lower long term capital gains rates.