Can I (legally) avoid paying tax on dividends?

Dividends are payments some companies make to shareholders to reward them for their investment in them. Dividends can provide regular, predictable income for investors who also retain the opportunity to benefit from price increases. Dividends may qualify for a favorable capital gains tax treatment if shares are held long enough. Avoiding all income taxes on dividends is more complicated. Options include owning dividend-paying stock in a tax-advantaged retirement account or 529 plan. You can also avoid paying capital gains tax on certain dividend-paying stocks if your income is low enough. A financial advisor can help you with dividend investing in your portfolio.

Dividend basics

Dividends are payments investors receive by owning shares of some companies. Companies that are profitable may pay out a portion of their profits as a cash payment or stock dividend as a way to reward shareholders for investing in the company.

Dividend paying stocks are popular alternatives to bonds for investors looking to generate passive income. Retirees often invest in dividends so they can make a living without having to sell stocks.

If you are ready to be matched with local advisors who can help you achieve your financial goals, start now.

Like all income, dividends are subject to taxes. The tax rates depend on whether dividends are considered qualified or non-qualified. Ordinary or unqualified dividends are paid on shares owned for less than the required holding period. These dividends are taxed at an investor’s ordinary income tax rate. Qualifying dividends paid on shares held for at least the required holding period are taxed as capital gains.

Capital gain rates are generally lower than ordinary income rates and range from 0% to 20%. Rates are based on taxpayer income and most taxpayers are in the 15% capital gains bracket. For example, an investor who earned $10,000 from qualified dividends would typically owe capital gains tax of $1,500, reducing their after-tax profit to $8,500.

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How to avoid taxes on dividends

There are a few strategies for avoiding taxes on your dividends, depending on whether they are qualified or ordinary dividends:

• Roth retirement accounts. A Roth IRA is funded with after-tax money. Once a person reaches the age of 59 ½, money can be withdrawn tax-free. So all dividends paid by shares held in a Roth account are tax-free, as long as the dividends are withdrawn after age 59 ½ and at least five years after the account was opened.

• Eligible for zero capital gains tax. Capital gains taxes are graduated, with higher income investors paying higher rates. Investors in the lowest income bracket are not subject to capital gains tax. Brackets change annually. For example, a married couple who jointly file 2023 taxable income of $89,250 or less would not pay capital gains tax on dividends. Strategies such as contributions to retirement accounts and health savings accounts (HSAs) can lower your income below the zero-tax threshold. As a result, you would not owe any taxes on qualified dividends.

• Plan education. Tax-advantaged 529 plans allow for tax-free growth and withdrawals as long as the funds are used to pay for eligible education expenses. So by putting money into a 529 plan and using the money to buy dividend-paying stock, you can collect tax-free money and also withdraw the money without paying taxes. However, this only works if the withdrawal amounts are for qualified educational expenses, such as tuition and books.

• Other retirement accounts. Other retirement accounts, such as traditional IRAs and 401(k)s, may offer partial income tax exemptions. These accounts are funded with pre-tax money. An investor can deduct money deposited in a traditional account from their current taxable income. But unlike Roth accounts, withdrawals are taxed as ordinary income. Holding dividend-paying stock in a traditional IRA or 401(k) won’t eliminate your tax liability, but it can reduce it.

It boils down

Investing in dividend-paying stocks can generate income while maintaining the potential for capital appreciation. Dividend income can be taxed at capital gains rates that are lower than tax rates on ordinary income, as long as the shares are held for at least one year. You may be able to avoid all income taxes on dividends if your income is low enough to qualify for zero capital gains if you invest in a Roth retirement account or buy dividend stocks in a tax-advantaged education account.

Investment tips

• Consider consulting a financial advisor for suggestions on tax-friendly ways to generate income through dividend investing. SmartAsset’s free tool pairs you with up to three vetted financial advisors in your area, and you can interview your advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

• To properly plan your financial future, you need to have an idea of ​​how much your investments will be worth in the future. SmartAsset’s Investment Return & Growth Calculator can help you estimate how much your portfolio could be worth. Specify the amount of money you’re starting with, the additional contributio
  ns you plan to make, your expected rate of return, and how long you want the money to grow. The calculator will then give you the estimated future value of your portfolio.

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