How to Protect Your Dividend Income from Taxes

Longitudinal studies of the stock market show that its behavior takes on patterns over time. For example, the market moves in a cyclical manner, and historically, it goes up over the long term. However, when investment horizons are shorter, the market is fundamentally unpredictable. Anything can happen, including sudden drops, with little or no warning.

When it comes to individual stocks, the uncertainty is even higher. Companies thought to have unlimited upside potential have abruptly lost billions in value. Apple made history in September 2020 when its market cap dropped by $182 billion in a single day.

Facebook parent Meta broke that record in February 2022, when its value declined by $232 billion in one day.

That sort of volatility is unmanageable for investors who rely on their portfolios for income. Instead of taking on the risk inherent in growth stocks, they focus on opportunities for reliable cash payments – primarily in the form of stocks that consistently reward shareholders with dividends.

There is just one problem with building a portfolio that successfully produces large amounts of dividend income: taxes. The tax rate on qualified dividends can be as high as 20 percent, and the tax rate on non-qualified dividends can go up to 37 percent.

In other words, without a comprehensive tax minimization plan, the value of dividend income goes down considerably once taxes are paid. Here’s how to protect your dividend income from taxes.

How to Avoid Paying Taxes on Dividends

When the goal is to protect dividend income from taxes, knowing which dividend income is exempt from taxes is a good place to start. Generally, there are three situations in which dividends are not taxed at all, as follows:

• Taxpayers who fall into the lowest three federal income tax brackets do not have to pay taxes on dividends. In 2023, that means a maximum of $44,625 for single filers or $89,250 for joint filers.

• Dividends paid on assets in tax-deferred or otherwise tax-advantaged accounts do not incur tax liability. Examples include dividends paid on assets in 401(k) plans, Roth IRAs, and certain college savings plans like Coverdell ESAs and 529s.

• Dividends that fall into a non-taxable category are not included in taxable income. For example, taxes are not assessed on return of capital, though it is important to keep in mind this type of income may lead to capital gains taxes at some point in the future.

A comprehensive tax minimization strategy aimed at protecting dividend income from taxes should consider these exceptions to dividend tax liability. Among other options, there may be opportunities to hold dividend stocks in a 401(k) or IRA rather than a standard brokerage account.

How to Reduce Your Dividend Tax Bill

If you can’t avoid paying taxes on dividends altogether, the next best thing is to maximize your dividend income after taxes. The first step in achieving that goal is to understand how dividends are taxed. There are two possibilities, depending on whether the dividends are qualified or non-qualified. Essentially, the difference between the two comes down to when and how long you have owned the stock and which exchange the stock calls home.

Qualified dividend taxes are assessed when dividends come from stocks you have owned for more than 60 days in a particular 121-day holding period that begins 60 days before the stock’s ex-dividend date. Qualified dividends are taxed at 0 percent, 15 percent, or 20 percent depending on the taxpayer’s total taxable income.

Note: The stocks must be in domestic companies that are headquartered in the United States or international companies that list their stock on one of the primary US exchanges to be considered qualified.

Nonqualified dividends, also referred to as “ordinary dividends” are any that do not meet the criteria for qualified dividends. This includes:

• capital gains distributions,
• dividends from non-profit or tax-exempt organizations,
• dividends related to deposits with certain financial institutions (e.g. credit unions),
• dividends paid on employee stock ownership plans (ESOPs) to employees, and
• dividends from non-US companies.

Ordinary dividends are taxed at the same rate as other taxable income, which ranges from 22 percent to 37 percent. Clearly, there are significant tax benefits to ensuring dividends fall into the qualified category.

Best Ways to Protect Your Dividend Income from Taxes

Outside of holding dividend stocks in tax-deferred or tax-advantaged accounts and prioritizing qualified dividends over nonqualified dividends, protecting dividend income from taxes is tough. Investors search for ways to reinvest dividends and avoid taxes or they choose a Dividend Reinvestment Plan (DRIP) to save on taxes with the idea that reinvested dividends aren’t taxed. That’s false – and the misunderstanding often leads to unpleasant surprises at the end of the year.

It’s a common misconception that dividend income is treated like capital gains income for tax purposes. Unfortunately, that’s simply not the case. While capital gains income isn’t taxable until the asset is sold and the gains are realized, tax liability attaches to dividends as soon as they are paid – even if they are immediately reinvested.

In short, whether dividends are reinvested or taken in cash, the IRS wants its cut. The companies paying out dividends send Form 1099-DIV: Dividends and Distributions to shareholders with a copy to the IRS, and shareholders must include the amount when completing tax returns.

Though it is possible to offset some of that tax liability with other types of deductions, the bottom line is that tax-deferred and tax-free plans are the best way to protect your dividend income from taxes.

That isn’t to say there are no benefits to participating in a DRIP. Automating dividend reinvestment is one of the best ways to boost long-term value of your portfolio. Better still, there are no commissions or fees for these transactions, and DRIPs offer the opportunity to purchase partial shares.

High-Yield Dividend Stocks for 2023

Whether you can minimize taxes through a tax-advantaged savings plan or not, high-yield dividend stocks are still a smart investment. Historically, quality dividend stocks have delivered better long-term returns than riskier growth stocks. These are ten of the best:

• 3M – 6.1 percent yield

• AbbVie – 4.1 percent yield

• Blackstone – 4.7 percent yield

• Brookfield Infrastructure – 4.1 percent yield

• Brookfield Renewable – 3.9 percent yield

• Chevron – 3.9 percent yield

• Duke Energy – 4.4 percent yield

• Pfizer – 4.5 percent yield

• Verizon Communications – 7.2 percent yield

• Walgreens Boots Alliance – 6.1 percent yield

Take special notice of 3M and AbbVie, which are recognized on the elite list of Dividend Kings – companies that have consistently increased their dividends for 50 or more consecutive years. As of 2023, 3M has increased its dividend for 65 years, and AbbVie’s dividend has gone up annually for the past 51 years.

Best Tax-Friendly Dividend Stocks Aren’t Stocks At All

Stock in for-profit companies rarely qualifies for special tax status, unless the stock is in an account that enjoys tax-deferred or tax-free earnings.

However, there are other types of assets that generate interest income for investors without incurring federal taxes. The most common asset in this category is municipal bonds. These are funds borrowed by cities and states for various projects, including enhancing infrastructure, supporting education, and funding community services.

The federal government excludes municipal bond interest income from taxable income, and when taxpayers invest in bonds issued by their home state, the interest is typically free of state income tax as well.

Buying municipal bonds directly isn’t always practical, but it is still possible to benefit from the tax advantages associated with this sort of investment. A wide variety of mutual funds and exchange-traded funds (ETFs) specialize in generating tax-free income for shareholders, so they build portfolios made up almost entirely of municipal bonds and other tax-free assets.

Some of the best tax-friendly funds include:

• Delaware National High-Yield Municipal Bond Fund Institutional Class (DVHIX) – 4.68 percent yield

• Fidelity Tax-Free Bond Fund (FTABX) – 3.68 percent yield

• T. Rowe Price Tax-Free High Yield Fund (PRFHX) – 3.78 percent yield

• Vanguard High-Yield Tax-Exempt Fund Admiral Shares (VWALX) – 4.23 percent yield

• Vanguard Tax-Exempt Bond ETF (VTEB) – 3.42 percent yield

It’s true that none of these funds offer spectacularly high returns, but the value of tax-free income can’t be ignored when the goal is preservation of wealth. That’s especially true for taxpayers in the highest tax brackets where rates can be up to 37 percent.

How to Protect Your Dividend Income from Taxes: The Bottom Line

The bottom line is that it isn’t easy to protect your dividend income from taxes. However, it is possible to shield a portion of that income with a comprehensive tax minimization strategy.

Focus on earning qualified dividends in brokerage accounts to avoid paying standard income taxes on dividend earnings.

Maximize use of tax-friendly plans, including retirement and college savings programs, to keep taxes on dividends low. Finally, consider alternative investments like municipal bonds and related funds, which don’t carry any federal tax liability.