When I first started investing, one of the most interesting things to me was the idea of dividends. Free money added back to my account, regardless of the price of the fund? That sounds amazing! If the fund doesn’t go up, at least I’ll still have money in my pocket. As I’ve grown to learn more about dividend funds (and more importantly taxes), my position on dividends has shifted and now I avoid them as much as possible.
So what are dividends? In short, they’re profit by the company (or companies) behind a stock or fund that are returned to the shareholder. This is usually stated as the “yield” when looking at a fund.
The 2.56% yield here means that over the last year this fund returned a 2.56% dividend back to shareholders. If you had invested $100,000 in this fund, you would have earned $2,560 in dividends. These dividends would most likely be added back to your account. At that point, you’d have control over what happens to them:
- Reinvest them back into this fund by buying more of it (most common).
- Invest them in a different fund.
- Take the cash and use it however you want.
This “profit” doesn’t need to be a company profit from sales either. This could be a bond that has matured and made money, a real estate investment trust (REIT) that made money through selling a property or (most commonly) a diversified index fund that is returning dividends from the companies within the fund.
If you’re like me when you first hear about dividends you might be thinking:
This seems like free money! Why would this be bad?!
And you wouldn’t be all wrong either. If you’re analyzing 2 funds that are otherwise identical and one of them has a dividend and the other doesn’t – the dividend fund is clearly the better choice. I haven’t had that ever be a tie-breaker, but it is one to consider.
Taxes for Dividends
Dividends aren’t “free money”. Dividends will be taxed when you receive them – if they’re in a taxable account. If your funds are in a tax-deferred account (IRA, 401k) or a tax-free account (Roth IRA, HSA) then congrats! You did just get free money! With the IRA/401k, you’ll still need to pay taxes when you withdraw, but that’s expected.
What’s less expected is how dividends are taxed in taxable/brokerage accounts. Let’s look at that $100,000 invested in $VBMFX again with the $2,560 in dividends. With dividends in a taxable account, things get more complicated. The dividends themselves are taxed at two different tax rates depending on the type of dividend you receive.
Qualified Dividends vs Unqualified Dividends
First, we need to know what amount of the $2,560 come from qualified dividends vs unqualified dividends. Every “dividend” created will be some combination of these two. The reason this distinction is important is that they are taxed differently:
- Qualified dividends are taxed at the long-term capital gains rate. (most likely 15% if your income is above $38,600/$77,200)
- Unqualified dividends are taxed at the short-term capital gains rate (which is your ordinary income rate).
As for why a dividend would be classified one way or the other, it gets a little confusing. In order to be a qualified dividend, it needs to come from a public traded company and you need to hold that share for at least 60 days prior to the dividend. The dividend also can’t come from an immediate sale or be unscheduled – as happens with REIT dividends. In other words, the best way to get qualified dividends is to buy and hold a stock fund.
Tax Brackets for Dividends
You will always pay fewer taxes on qualified dividends than unqualified dividends. Depending on your tax rate, the amount you’ll pay in taxes will be very different. For qualified dividends, if you’re making less than $38,600 (single filer) or $77,200 (joint filing), then you’ll pay $0 in taxes on qualified dividends due to your capital gain rate! Here are the full table on the rates for these for 2018:
2018 Income Tax Brackets
|Tax Rate||Individuals||Married, Filing Jointly||Long-Term Capital Gains Rate|
|10%||Up to $9,525||Up to $19,050||0%|
|12%||$9,520 to $38,700||$19,050 to $77,400||0%|
|22%||$38,701 to $82,500||$77,401 to $165,000||15%|
|24%||$82,501 to $157,500||$165,001 to $315,000||15%|
|32%||$157,501 to $200,000||$315,001 to $400,000||15%|
|35%||$200,000 to $425,800||$400,001 to $479,000||15%|
|35%||$425,800 to $500,000||$479,001 to $600,000||20%|
|37%||Over $500,000||Over $600,000||20%|
Whatever range your income (after your personal deduction or itemized deductions) falls in is the rate you’ll pay for any dividends you receive. Between these two, you want any dividends to be taxed at the long-term capital gains rate, but it’s even better if they’re not taxed at all!
The annoying part is that for our $2,560 in dividends from the bond fund we talked about would mean we would pay taxes of $384 each year (if in the 15% long-term capital gains bracket). Over 30 years, that’ll be around $12,000 not invested back into the stock market. If you run this through a compound interest calculator (which of course I did) then that $384 a year becomes $38,812 over 30 years! That’s potentially a pretty big chunk of one-year spending right there.
If your income is below the 15% rate, congratulations! You don’t need to worry much about dividends now. I would still be cautious about them. If your income were to rise later, all of the sudden you would start to become accountable for paying taxes on them. If you’re still young and making less than this now, but think your income will grow, take the time now to set yourself up tax-advantaged funds today. It’s much harder to change this later, especially in brokerage/taxable accounts.
How Do You Avoid Dividends?
If dividends are taxed when they’re received, there are three ways to avoid paying any taxes on them whatsoever:
- Hold long-term and make under $38,600/$77,200
- Hold them in a tax-advantaged account
- Choose more tax-efficient funds
Hold long-term and make under $38,600/$77,200
One very important thing to note here: this isn’t your spending, this is your income! Here are three quick examples for how you could have $70,000 in income during a year:
- You have a W2 job that pays you $70,000 a year. (~$56k spendable cash after $14k tax)
- You’re 60 years old and you withdraw $70,000 from your 401k. (~$56k spendable cash after $14k tax)
- You have dividends of $5,000 and sell $100,000 in stock. The stock was originally bought for $35,000 – giving you $65,000 in capital gains ($65k + $5k = $70k). ($105,000 spendable cash after $0 tax)
The key part to all this is that qualified dividends (and capital gains in general) can be greatly reduced by making under $38,600/$77,200. Also for all of these numbers, you’ll also get a personal deduction ($12,000 individual / $24,000 filing jointly) which will lower the income even more!
Hold them in a tax-advantaged account
Dividends in a tax-advantaged account are easy, there’s nothing to worry about there. Every time I get dividends it’s free money that gets immediately reinvested into the fund! Since these aren’t taxed every single year, they’ll grow much more in a tax-advantaged account than would be possible in a taxable one.
Choose more tax-efficient funds
Take a look at these two similar funds. They are both have a yield of over 2% each year. The difference is that the $VWITX’s dividends are federally tax-exempt dividends! The reason for this has to do with what type of bonds the fund invests in. Vanguards Total Bond fund invests in all types of bonds – ones from companies, from states, from companies outside the US — everything. $VWITX invests solely in municipal bonds – bonds from states in the US. That makes their dividends federally tax exempt.
These are highly stable too – there’s very little chance the state of California is going to suddenly fail (or if it does, there are bigger problems than our bond fund). Looking at the top 5 holdings from this fund we see very familiar names:
- Metropolitan Transit Auth (New York Subway)
- CENTRAL PLAINS ENERGY PROJ NEB
- UNIVERSITY CALIF
- Kentucky Inc Ky Pub Engy Aut Bds
- MARYLAND ST
Investing in transportation, education, and energy in the states? That sounds like a solid investment. The fund itself holds 7,635 bonds as of today, so you’re insulated against individual bonds failing.
We ran out of tax-advantaged space in our 401k/Roth IRAs before we could reach the number of bonds we wanted to hold. I started looking around for what bond fund to hold in my taxable account and $VWITX/$VWIUX (which is the admiral version of the same fund) stood out the best option.
We now hold more than $100k of this fund in our taxable account. It’s the core bond fund we use whenever taxes would become a problem. Looking at my 1099 tax form from Vanguard from last year, there’s a page that lists out all dividends received during the past year. On that form, there’s a column for “Exempt-interest dividends”. That’s the column where all dividends from $VWIUX are listed. Even though I didn’t hold the fund for a year before getting these dividends, they were still exempt!
Dividends Aren’t All Bad
I’ve painted dividends in a bad light in this post, but there are cases to be made for them – if you’re in a low tax bracket. Even with a low tax bracket, it’ll be hard to know what percent of your dividends are short-term vs long-term. Vanguard has a handy list that describes how much of each fund’s dividends were qualified vs unqualified which can help understand which funds are best to hold in a taxable vs tax-advantaged account.
If you’re in a tax bracket where you’ll pay taxes on dividends I’d strongly encourage you to think twice about them. Do you really want to pay taxes on them now? Wouldn’t you rather have a fund that appreciates in value instead? Or perhaps a municipal bond fund that allows for tax-exempt interest?
If you’re trying to optimize your taxes, make sure you understand how dividends play into that while you’re working and again when you’re relying on them for income.