Are Stock Dividends Taxed as Ordinary Income?

Posted Jan 28, 2023

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For many taxpayers, there is a substantial difference in the tax rate they pay for long-term capital gains versus the rate they pay for ordinary income. The tax rates on ordinary income range from 10 percent to 37 percent. In comparison, the rate applied to long-term capital gains income is between 0 and 20 percent. The income taxed at the “ordinary” rate includes salary and wage income, commission, bonuses, rents, royalties, short-term capital gains, interest, and unqualified dividends.

What is the difference between qualified and unqualified dividends?

First, it’s necessary to understand what a stock dividend is. It’s a payment that corporations pay to their stockholders, usually reflecting a portion of their profit. Many companies pay dividends regularly, often each fiscal quarter. Investors may seek dividend income as part of a retirement strategy.

However, many successful companies decline to issue dividends, instead preferring to reinvest profits in the company’s growth, innovation, and diversification. Prominent examples include Amazon, Facebook (Meta), and Google (Alphabet). The leadership of companies that shun dividends states that they prefer to raise the overall stock value.

Most US corporations that offer dividend income issue qualified dividends, which means they are taxable at the same rate as long-term capital gains, not the higher ordinary income rate. Foreign corporations pay unqualified dividends unless the company has an income tax treaty with the US or the stock is widely traded on a US-based exchange. Distributions from Real Estate Investment Trusts (REITs) also issue unqualified dividends (with some exceptions) because the income they earn is not taxed at the corporate level.

Does the holding period matter?

The distinction between qualified and unqualified also depends on how long you own the stock. An investor must hold the stock for 60 days before the ex-dividend date (the day before any dividend is announced) to benefit from the qualified status and the lower capital gains tax rate. Also, you can’t hedge your exposure during the qualifying period by using short sales, puts, or calls.  

Why would a company stop paying a dividend?

If a corporation is a reliable issuer of stockholder dividends, it can cause an uproar and backlash from those stockholders with a decision to suspend dividend payments. Frequently, the motivation is financial hardship. The company may prudently decide to retain its profits rather than distribute them. This choice is more likely if the company expects the downturn in profitability to be sustained.

Sometimes, a company might issue both preferred and common stock dividends. Preferred stock does not confer voting rights but has priority for dividend payments. So, common stock isn’t eligible for dividends until preferred dividends are paid. As a result, the company might suspend both types or pay the preferred dividends only. No noteworthy US companies interrupted dividend issuance in 2022, although some implemented sizeable reductions1.

1 WSJ, Mark Maurer, Companies Spend Record Amounts on Dividends, Despite Looming Downturn, December 30, 2022

 

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.

Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.

The actual amount and timing of distributions paid by programs is not guaranteed and may vary. There is no guarantee that investors will receive distributions or a return of their capital. These programs can give no assurance that it will be able to pay or maintain distributions, or that distributions will increase over time.

The income stream and depreciation schedule for any investment property may affect the property owner's income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.

A REIT is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages.

REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate.

There are risks associated with these types of investments and include but are not limited to the following:

  • Typically, no secondary market exists for the security listed above.
  • Potential difficulty discerning between routine interest payments and principal repayment.
  • Redemption price of a REIT may be worth more or less than the original price paid.
  • Value of the shares in the trust will fluctuate with the portfolio of underlying real estate.
  • There is no guarantee you will receive any income.
  • Involves risks such as refinancing in the real estate industry, interest rates, availability of mortgage funds, operating expenses, cost of insurance, lease terminations, potential economic and regulatory changes.

This is neither an offer to sell nor a solicitation or an offer to buy the securities described herein. The offering is made only by the Prospectus.

There is no guarantee that companies that can issue dividends will declare, continue to pay, or increase dividends. 

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