Dividends are one of my favorite things to collect. Even John D. Rockefeller understood the power of dividends. He has been quoted as saying, “Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.” Buy a stock that pays a dividend, and a company pays you passive income every quarter in the U.S. and semi-annually in most other countries. However, in most cases, everyone must pay taxes on dividends. In the U.S. and most other countries, for that matter, dividends are considered income, and hence they are taxed. In the U.S., though, dividends can have favorable tax treatment for many small investors, making them tax efficient in regular brokerage accounts. It is also possible for dividend-paying stocks to be held in tax-advantaged accounts delaying or reducing federal income tax on dividends.
1. Why do Investors Love Dividends So Much?Why do dividends matter to investors? There are several reasons investors like dividends. One of the most important is that dividends are a return of cash to an investor. A company can return some money to stock owners by buying back shares or paying a dividend. However, when a company pays a dividend, the investor decides what to do with that money. You can reinvest the money and buy additional shares of the same company. Alternatively, you can purchase shares of a different company. A third option is that you can keep the cash and do something else with it. John Bogle said it best: “Successful investing is about owning businesses and reaping the huge rewards provided by the dividends and earnings growth of our nation’s–and, for that matter, the world’s– corporations.” Dividends are also a metric used to determine financial health. Companies that pay a dividend have the earnings and cash flow to do so. However, when companies experience financial difficulties, such as during times of economic duress, they may freeze their dividends or, even worse, cut or suspend their dividends. For instance, during the sub-prime mortgage crisis and the Great Recession from 2008–2009, many banks slashed their dividend rates to zero. Similarly, during the COVID-19 pandemic, many companies in the energy, retail, travel, and hospitality industries cut or suspended their dividends. These companies faced low oil prices and plunging demand, severely impacting their revenue, earnings, and cash flow. Dividends can also contribute to total return, lower portfolio volatility, and provide downside protection when the market is declining. Historically, dividend-paying stocks have outperformed those that do not pay dividends. Importantly, dividends may also be tax-efficient since tax on a certain type of dividend is treated favorably at the long-term capital gains tax rate.
2. What is the Tax Rate on Dividends?Dividend tax rates differ depending on whether the dividend is qualified or nonqualified, also known as ordinary. The difference in the tax rate can be dramatic depending on your income. Families in the highest income tax bracket pay a 37% tax rate on regular income and only a 20% tax rate on dividends. For families closer to the median U.S. family income of about $67,521 in 2020, the tax rate on regular income is 12%, but it is 0% on dividends. Think about it; you pay no income on your dividends. No wonder dividend-paying stocks have become so popular in the past decade.
Qualified Dividends?The concept of qualified dividends was implemented in the U.S. when the 2003 tax cuts were signed into law. Before this law went into effect, dividends were taxed at the regular income tax rate. Qualified dividends have an advantageous tax rate. But not all dividends are qualified. According to Investopedia, a dividend must meet the following criteria to be qualified.
- Paid by a U.S. company or a company in a U.S. possession
- Paid by a foreign company residing in a country that is eligible for benefits under a U.S. tax treaty
- Paid by a foreign company that can be easily traded on a major U.S. stock market