The Do’s and Don’ts of Taxes & Dividends

Dividend-paying stocks have soared in popularity over the past decade. If you’ve made room for dividends in your portfolio–or you’re planning to do so–here are some dos and don’ts to bear in mind.

Do: Know the Difference Between Qualified and Non-qualified Dividends

The Jobs and Growth Tax Relief Reconciliation Act of 2003 created a new category of dividends: qualified dividends. These are eligible for the new lower tax rate. Dividends from most U.S. stocks are qualified. But non-qualified dividends are still dunned at investors’ ordinary income tax rates. So, it’s important to look closely before stashing dividend-payers in a taxable account.

Do: Check a Dividend Fund’s Composition Before Assuming It’s Tax-Friendly

Qualified dividends are eligible for the lower tax rate. This makes dividend-focused funds more tax friendly than they were in the past. Most such funds invest the lion’s share of assets in stocks. But, they also may hold shares of “other” securities to boost their yields and improve the fund’s defensive performance. Income from such securities is taxed as ordinary income, and can boost a fund’s tax costs.

Don’t: Put High Dividend-Payers in Your Taxable Account If You Can Avoid It

If you need income from your taxable portfolio and are spending your dividends as you earn them, then holding those dividend-payers in your taxable account is reasonable. But if you’re reinvesting those dividends in a taxable account, you’re effectively paying tax on part of your return before you actually need to. You’ll pay tax on your dividends in the year in which you receive them, whether you reinvest the money or spend it.

Don’t: Forget to Account for Reinvested Dividends

It’s very important to properly account for dividend distributions that you’ve reinvested. While you pay taxes on those dividends when you reinvest them, you’re allowed to increase your cost basis. This effectively offsetting the taxes you already paid on that dividend. Mutual fund firms and brokerages are now required to track investors’ cost basis and will probably do a better job keeping track of reinvested dividends and capital gains than investors could do with their own spreadsheets.

Read the full article by Christine Benz to learn more.