What is Dividend Income and How is it Taxed?
By: Ned Piplovic,
In its simplest definition, dividend income is a stream of funds that investors receive from dividend distributions.
The importance of dividend income can be different for different investors. The degree of importance that various investors place on dividend income can depend on other income sources, investors’ ages or a number of other factors within investors’ overall portfolio strategy.
For instance, investors with a regular primary source of income from a job might focus their strategy on capital growth and wealth building for retirement. Younger investors might follow a similar investment strategy. However, investors approaching and reaching retirement age should rebalance their portfolio to include a high share of dividend-paying securities.
Therefore, just like they invest into their portfolio, investors should invest the necessary time and effort to understand the basic dividend income precepts to increase the probability of selecting securities with the best chance of building long-term wealth or generating the highest potential dividend income. Furthermore, some investors are too focused on picking investments with the highest available gross returns. With such a narrow focus, some overlook that the net amount of investment funds an investor keeps is more important than the total gross returns. Therefore, a basic understanding of different dividend income types, as well as how each income type is taxed, will assist in selecting the individual investments best suited to every investment portfolio.
This article does not encompass all the necessary information on the relevant topics by a wide margin, However, this article will provide the fundamental concepts and terminology that even novice investors can use as a springboard to jump into the realm of dividend income to continue to learn and discover various nuances of dividend distributions and variations in dividend investment strategies.
Dividend Income Basics
Whether the distributions are called dividends when distributed by a C-Corporations or a distribution when distributed by a limited liability corporation (LLC), the dividend principle remains unchanged. Regardless of the equity’s legal definition and organizational structure, equities distribute a portion of their earnings or assets as periodic payments to their stake holders. These periodic payments are the dividends or distributions. The aforementioned LLCs – as well as S-Corporations, partnerships, estates, trusts, etc. – technically pay distributions.
However, for simplicity, the remainder of the text will use the term “dividend” to designate both payout types, unless the difference between the terms has a specific impact on other concepts discussed. One example where this terminology distinction matters is for taxation purposes. Equities generally pay dividends from earnings, and equity payouts typically fall under the distributions’ category. The tax code treats these two income types differently and applies different tax rates.
Dividend-paying equities allocate a portion of their earnings and return to their stockholders in regular intervals as dividend income. These distributions can occur monthly, quarterly, semi-annually or annually. Companies based in the North America favor quarterly distributions because this payout schedule aligns with the quarterly financial reporting requirements. However, because of the local requirement for semi-annual reporting of financial results, many companies in Europe and Japan follow the same schedule and distribute dividend income payments twice per year. The decision on the dividend distribution timing is completely at the discretion of the company’s dividend policy.
In addition to its regular dividend distributions, equities occasionally distribute special dividends. These distributions are one-time special dividends designed to distribute extraordinary earnings, unplanned cash inflows or asset sales to the equity’s stakeholders. The sources for the special dividends include business divestitures, lawsuit awards, investment liquidations, etc.
Benefits of Dividend Income
Financial experts somewhat disagree whether dividend distributions have any benefit at all. Supporters of a theory developed by economists Franco Modigliani and Merton Miller in the 1950s insist that – assuming perfect market conditions – dividend distributions do not have any effect on long-term capital gains. The Modigliani-Miller Theorem claims that dividend distributions are a valid business strategy only if a company has no alternative opportunities to invest the excess earnings. However, investors who hold the pro-dividend side of the argument point to back-tested data of historical market performances to support the claim that companies with rising dividend payouts perform better over the long-run than their dividendless peers.
Why would a company pay a portion of its earnings and not use those funds to expand business and increase its value over the long-term horizon? While there might be many reasons for dividend distributions, the main reason is that investors seek to walk that thin line between long-term capital gains and short-term income generation. Individual investors might have different goals. Some investors look at the long term, some seek immediate returns and cash distributions and other investors look for innumerable variations of the combination of the two extreme points. Stockholders of any equity are spread across all these different groups.
Therefore, equities aim to attract and to keep happy a wide variety of investor types. A company that manages to maintain a large number of satisfied shareholders also will have the ability to raise capital to support future operations and expansion, which is key for long-term profitability.
Dividend Income Types
The most frequent type of dividend income distributions are cash payouts. Cash dividends are easy to distribute for the equity making the payouts and easy to manage for the investors receiving the income. However, sometimes equities will distribute in-kind dividends, which might include stock dividends, property dividends, bonds of the company distributing dividends, bonds of a different corporation, government bonds, accounts receivables and promissory notes. In addition to the apparent differences between the dividend types, different types of dividend payouts are treated differently for taxation purposes.
Taxation of Dividend Income
Equities benefit from distributing stock dividends because stock dividends do not have any effect on a company’s cash flow. The Internal Revenue Service (IRS) treats stock dividends as stock splits for taxation. Therefore, investors who receive stock dividend distributions carry no tax liability on those dividends until they sell those shares. Additionally, even at the time of sale, those shares are taxed at capital gains rates, which generally are lower than ordinary income tax rates applicable to many cash dividends.
However, some cash dividends can enjoy the benefit of taxation at capital gains rates. These distributions must meet specific IRS requirements to attain the qualified dividends designation and the benefit of taxation at capital gains tax rates.
Even investors that are not tax experts can differentiate the tax liability impact by the location of the dividend amount reported on the IRS 1099-DIV Form. Generally, the total amount of ordinary dividends will be listed in the 1a box at the top of the form. Alternatively, the qualified dividends amount taxable at capital gains rates will appear in box 1b of the same form.
The tax rates for ordinary income are subject to the ordinary income tax rates and brackets.
The Tax Cuts and Jobs Act (TCJA) passed by Congress on December 22, 2017, revised the tax bracket structure for qualified dividends. The table below presents the rates and applicable income limits for qualified dividends.
While dividend distributions are a relatively simple concept in its basic form, executing a successful dividend income strategy over the long term requires deeper understanding of dividend metrics and financial market operations. However, income-seeking investors should not discourage easily as even minor efforts can provide significant returns on capital and time investments. Furthermore, even investors who do not feel comfortable engaging in their own analysis could benefit from dividend income distributions by investing in one or more of the Dividend Aristocrats or one of the ETFs that track the performance of high-dividend stocks.
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