How Do Dividends Affect My Taxes?

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This post originally appeared on InvestingAnswers.

It seems monstrously unfair that you have to pay taxes on dividends.

After all, that money has already been taxed. A company that pays out dividends pays taxes on its own income and shares the profits in the form of a dividend payout to shareholders.

The unfairness of it, though, doesn’t stop Uncle Sam from wanting his cut of your dividend earnings. If you are going to invest in dividends and you want to legally cut your tax bill, you need to know how it works.

Before you invest in dividends, here are a few things to know:

Dividends are a category separate from regular income and capital gains.

Dividends are not considered capital gains. As a result, they are not seen as “long-term” or “short-term.”

While in recent years the tax rate has been the same for “qualified” dividends as long-term capital gains, don’t get too used to this — the tax rate on dividends can change regardless of what is happening with the long-term capital gains tax rate.

In the past, dividend earnings have been treated as regular income and taxed at yourmarginal tax rate. However, dividends aren’t exactly considered regular income. They are separate and have, since the implementation of the so-called Bush tax cuts, enjoyed special tax consideration.

Wealthy dividend investors face a tax hike starting in 2013.

The special treatment for dividend earnings was to expire at the end of 2012. The fiscal cliff tax deal, though, changed things a little. Dividends retain a favored tax status — with those in the 10% and 15% brackets still paying 0% on “qualified” dividend earnings, while others pay 15%.

High earners face a different fate. Those filing singly who earn $400,000 a year and those filing as married who earn $450,000 a year will see a tax rate of 20% on qualified dividends starting in 2013. If you are a high earner and can find a way to keep your income below the threshold, you won’t be subject to the higher tax rate.

Here’s what the IRS considers a “qualified” dividend.

No dividends enjoy the special tax treatment. Make sure your dividend earnings are “qualified.” Here are the exact words the IRS uses to define what “qualifies” a dividend for the special tax rate:

“[Y]ou must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.”

And, for preferred stock:

“[Y]ou must have held the stock more than 90 days during the 181-day period that begins 90 days before the ex-dividend date if the dividends are due to periods totaling more than 366 days.”

The ex-dividend date — as stated in our Financial Dictionary – is the day on which all shares bought and sold no longer come attached with the right to receive the most recently declared dividend.