Many investors choose to invest in dividend-bearing stocks, or mutual funds focusing on dividend payers, as part of their portfolio. And those dividends can pay off in a major way. Investing in dividend-bearing stocks can be a great choice for investors who are thinking long-term. You may receive dividends in stock or cash, and you can frequently reinvest cash dividends to buy more stock.
Depending upon how you receive dividends, you may need to plan ahead for tax day. Specifically, it is important to understand the different types of dividends, what you can expect as far as paying taxes on them, and how to read the 1099-DIV tax form so you’re adequately prepared.
Types of Dividends
There are three main categories of money you might receive: ordinary dividends, qualified dividends, and capital gain distributions. Each type has its own tax implications.
- Ordinary Dividends. Dividends paid out from a company’s earnings and profits are referred to as ordinary dividends. They are taxed at normal income tax rates. Many real estate investment trusts (REITs), for example, pay out ordinary dividends, which can raise your overall tax burden. These are sometimes referred to as “non-qualified dividends” and are reported in box 1a of the 1099-DIV.
- Qualified Dividends. Dividends may be considered qualified if they’re paid by a U.S. corporation or qualified foreign corporation and you’ve met the holding period requirement for the underlying stock. Qualified dividends are subject to long-term capital gains tax rates and are reported in box 1b on your 1099-DIV.
- Capital Gains Distributions. You may also receive payments from your dividend-paying stock in the form of capital gains distributions. These are generally received from mutual funds and are reported in box 2a on your 1099-DIV and are subject to long-term capital gains rates (regardless of how long you owned the shares).
Keep in mind that you must report all dividends received on your taxes, but the company that paid dividends doesn’t have to send you a 1099-DIV unless you received more than $10 that year. In other words, maintain a record of how much you earned in case you don’t receive a 1099-DIV.
What Is a Dividend Reinvestment Plan?
A DRIP, or dividend reinvestment plan, is a method that allows you to use your dividends to purchase more of the same stock instead of receiving the dividends in cash. Simply put, instead of receiving $3.24 in dividends, the company automatically purchases for you however many shares (or portions of a share) that $3.24 will buy. This nets you a little more stock each time, so that, ultimately, you end up with more shares than you started with.
However, even when dividends are reinvested, you receive a 1099-DIV with the dividends reported on it. In the eyes of the IRS, this circumstance is the same as if you received a check for $3.24 and then immediately purchased $3.24 worth of the stock. A DRIP is simply more convenient and has additional advantages to purchasing stock, such as dollar cost averaging.
Taxes on DRIP Purchases
Each quarter, when your dividend payments are automatically reinvested to acquire more stock, you inevitably buy shares at different prices, which determines your cost basis in those shares. When you eventually sell your stock for a capital gain or loss, you need to know your cost basis for each share sold.
Hold onto the quarterly statements you receive, which reflect how many shares were bought, at what price, and on which day the investment was made. You can then determine your actual profit. Some software programs and most brokers also keep track of this for you.
1099-DIV Tax Form
The 1099-DIV is the tax form that you receive from each company that sends you dividends (or with whom you’ve started a DRIP plan) if it paid you $10 or more in dividends or withheld any taxes from your dividends (or if the company was liquidated and you received a liquidating distribution). This document splits out the types of dividends you received as follows:
- Box 1a – Total Ordinary Dividends: All ordinary dividends are reported here. These dividends are taxed at the same rate as your ordinary income.
- Box 1b – Qualified Dividends: Your qualified dividends are taxed at long-term capital gains rates instead of ordinary income tax rates.
- Box 2a – Total Capital Gains Distributions: Amounts here are also taxed at long-term capital gains rates.
- Box 2b – Un-recaptured Section 1250 Gain: You may realize this type of gain from certain real estate or REIT transactions.
- Box 2c – Section 1202 Gain: This box reports income that is a section 1202 gain from small business stock.
- Box 2d – Collectibles Gain at 28%: If artwork or other collectibles you held for investment purposes were sold, the profit is taxed up to a maximum of 28%. If you held for less than a year, it’s taxed at ordinary income tax rates.
- Box 3 – Non-dividend Distributions: If you received non-dividend money from a company, it is reported here.
- Box 4 – Federal Income Tax Withheld: If you’re subject to backup withholding and a company withheld taxes from money reported on the 1099-DIV, it is reported here.
- Box 5 – Investment Expenses: If you received a share of amounts deductible by a non-publicly offered RIC (regulated investment company), they’re entered here.
- Box 6 – Foreign Taxes Paid: If foreign taxes were paid on dividends and other stock distributions, they’re reported here.
- Box 7 – Foreign Country: In this box, the country to which foreign taxes were paid (the amount in box 6) is reported.
- Box 8 – Cash Liquidation Distribution: If a company was liquidated, this is the liquidated amount paid to you.
- Box 9 – Non-Cash Liquidation Distribution: This section reports non-cash distributions and their fair market value.
- Box 10 – Exempt-Interest Dividends: In many cases, you do not have to pay taxes on exempt interest dividends.
- Box 11 – Specified Private Activity Bond Interest Dividends: This box reports exempt-interest dividends paid by a RIC from specified private activity bonds.
- Box 12 – State: If you had state income tax withheld from these earnings, this box reports which state.
- Box 13 – State Identification Number: The state identification number of the firm that withheld state income tax is entered here.
- Box 14 – State Tax Withheld: The amount of state income tax withheld is reported here.
In general, taxes on dividends are pretty simple. Most tax preparation software programs ask you to input the information from your 1099-DIV, and then proceed to make the necessary calculations for you and record them on the appropriate tax forms. However, it’s important to know what you earn over the course of the year in dividends in order to anticipate how much your tax bill will increase as a result.