Taxation of Dividend Income and Other Distributions- Know it Right

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It’s easy to get stuck up in choosing investments and overlook the tax effects—most especially, capital gains tax. After all, picking the right stock or mutual fund may not be enough without calculating the taxes on it.

What Are Dividends?

In common man’s language Dividends is the return on your investment in stocks, shares, or mutual funds. They represent the profit gained by funding in stocks, mutual funds, or exchange-traded funds and they are included in your tax account on Schedule B, Form 1040. Wealth gains or Capital gain is the amount by which an asset rises in value in the time between when it is acquired and when it is sold.

As per the Tax Laws in the USA the tax treatment of dividends and short-term money gains is different from the tax treatment of qualified distributions and long-term capital earnings. Investors that get dividends or capital profits are required to pay taxes on those earnings. Short-term capital gains and ordinary dividends are treated the same as income and taxed at the contemporary income tax level. Long-term capital gains and qualified dividends have beneficial tax treatment that is lower than ordinary income tax rates.

Types of Dividends

For tax purposes Dividend can be classified as

1. Ordinary Dividends – They represent the money that is paid by a corporation to its shareholders out of the profits earned by the Corporation.

2. Qualified Dividends- They are the receipts that are qualified to be taxed at capital as capital gains. A dividend is Qualified if

  • It is paid by a U.S Company or a qualifying Foreign Company
  • It is not by IRS as “ Not Qualified”
  • It is received in relation to the Investment which is held for more than 60 days throughout the 120 days period which begins 60 days before

Other Distributions

Tax-exempt Dividends

Tax-exempt dividends from a mutual fund return exempt the dividends when profit is produced to the shareholder. Tax-exempt interest dividends from mutual funds aren’t payable, but you should report them on your return if you’re expected to file. Dividends exempted from interest are subjected to Alternative Minimum Tax (AMT). Exempt interest dividends are reported to a taxpayer on Form 1099-DIV, whether or not it’s subject to AMT.

Dividends on Insurance Policies

Insurance policy dividends aren’t taxable. However, you must report as a taxable interest that is charged on dividends left with the insurance company. If dividends are issued to you, they are a premium return that must not be included in the gross income. Only if the amount is more than the total you paid, then only it is considered in gross income. Dividend on insurance policies is reported under Schedule 1 (Form 1040), line 8.

Patronage dividends

Generally, patronage dividends you receive in money from a cooperative organization are added to your income.
Don’t include patronage dividends you receive on:

  • Property bought for your personal use, or
  • Capital assets bought for use in your business.

But you must reduce the cost of the items bought. If the dividend is more than the fixed basis of the assets, report the excess as income.

Tax rates on Dividend Income

Tax Treatment of Capital Gains

Capital gains tax rates point to be more beneficial than income tax rates. The benefit from Capital gains tax depends on how long the merchant controlled or held the asset. Short-term capital gains for assets owned for a shorter than a year are taxed under ordinary income rates.

However, if an asset is held for more than a year, then more long-term capital gains are implemented. The rates go as 0%,15%, or 20%—depending upon your earnings.

For instance, if we talk about the 2020 tax year, if you have a total income of $40,000 or less, you pay 0% on long-term capital gains. 15% if you have an income of $441,450 or less, and 20% of your income exceeds $441,450.

The businesses use capital losses to compensate for capital gains in a given tax year, diminishing the taxes due- Note that only short-term losses can offset short-term earnings, and it goes vice versa for long-term losses.

Tax Treatment of Ordinary Dividends

The treatment for Ordinary dividends is similar to short-term capital gains- those on short-term assets for less than a year are subjected to the effective income tax rate. As defined by irs.gov, qualified dividends are taxed at a lower rate and prove to be more beneficial than the individual income. Qualified dividends are those financed by domestic or qualifying foreign businesses that have been retained for at least 61 days out of the 121 days starting 60 days before the ex-dividend date.

Tax Treatment of Qualified Dividends

In the case of qualified dividends, the taxation method is the same as long-term capital gains. As in the given the tax year of 2020, individuals in the 10% to 15% tax bracket are excused from any tax. Investors who fall in this capital gain range pay 15% in this case—25%, 28%, 33%, or 35%.

Reporting Dividend Income in Tax Return

Usually, you need to use form 1040 to file your dividend earnings. Document the entire of your regular dividends on line 3b of form 1040.

Report qualified dividends on line 3a of form 1040. In case you receive non-dividend distributions required to be suggested as capital, you need to use Form1040. In case you owned inventory on which you received $10 or extra in dividends and other distributions, you ought to acquire a form 1099-div. Even if you don’t get hold of form 1099-div, you should record all your dividend profits.

Reporting on Form 1040

Report dividend income on your tax return in the following places:

  • Ordinary dividends- Line 3b of your Form 1040
  • Qualified dividends- Line 3a of your Form 1040

Reporting on Form 1099

Form 1099-DIV is allotted to investors by mutual fund firms, stockbrokers, and enterprises, when $10 or more in dividend income is paid out during the year.6 Form 1099-DIV, proclaims dividends data in the following areas:

Box 1a: Ordinary dividends speculating the total value of dividends paid to you.
Box 1b: Qualified dividends—the part of total dividends, that restrain the favored capital gains tax rate.
Box 3: Non-dividend distributions, which are a nontaxable return of capital (ROC).

Using Schedule B

Schedule B is a supplemental tax form used to register interest and dividend income from various sources. Employing Schedule B is required if you have a dividend or interest income over $1,500.

Conclusion

Be careful in identifying the kind of dividends receipt and its related taxation before filing your annual Federal Tax Return.