While I’ve already explained what a dividend is, let me take this opportunity to explain how long you need to hold a particular stock/ETF to be eligible for a dividend payout, how much you’re taxed and what dividend aristocrats are.
Technically, you are required to own a stock for atleast two business days (when the markets are open) to receive an announced dividend. Diving a bit more in detail, we take a look at the “ex-dividend” date.
This is the date when a stock’s share(s) trade without a dividend payout. If you buy a stock on said date, you are ineligible to receive the dividend payment for that cycle (month/quarter/year).
For example, if you were to buy a share of a stock that yields $4 in annual dividends paid out quarterly on the ex-dividend date, you’d miss out on the $1 for that particular quarter but will be eligible to receive it the next cycle.
This is the date by which you should officially be a registered shareholder (own the share) and is generally a day after the ex-dividend date. Hence, to receive a dividend payout, you need to own the share(s) two business days before this date.
This is the date you receive the dividend yield into your account.
Types of Dividend
It’s important to understand the two types of dividends as they get taxed differently depending on how much income you make collectively (including part/full time jobs/other income).
These are taxed at ordinary income tax rates. The tax rate you pay on the earned “ordinary” dividends is the same as what you’ll pay on your overall income in that fiscal year. These are also referred to as non-qualified or unqualified dividends.
For example, if you was in the tax bracket of 10-15% based on your existing/current income, that’s the tax rate you’ll pay on any earned dividends.
The rationale behind being taxed ‘more’ is that they’re paid out of earnings, and are thus ordinary income to the individual taxpayer and not capital gains like the stock price going up.
Not all stocks will pay qualified dividends and to receive a qualified dividend, there are some conditions required to be met.
- You must be paid by either a U.S. company, a qualified foreign corporation (one incorporated on U.S. soil or whose country signed an income tax treaty with the U.S.), or their shares must trade on an American exchange.
- They must not satisfy conditions the IRS lists as “dividends that are not qualified dividends,” which include capital gain distributions, dividends from tax-exempt corporations, and payments in lieu of dividends, to name a few.
- An investor must have held the stock for more than 60 days in the 121-day period that starts 60 days before the ex-dividend date.
However, some stocks (including capital gains distributions, payouts from REITs, MLPs, LLPs) aren’t eligible for the lower tax rates offered by qualified dividends thus shifting the burden onto the shareholder. They avoid paying corporate-level taxes by passing through at least 90% of their income to shareholders.
As per the IRS, it’s always better to assume a dividend is ordinary unless you are informed by the stock issuer/ETF/MF.
One important piece of information you should always keep in mind is that qualified dividend paying stocks are better to be held in taxable (brokerage) accounts than those that are unqualified. For example, it may be better to hold REITs in a Roth IRA account (not subject to taxes) than a regular brokerage account – I keep my REITs in my normal account but just sharing this as an example.
Paying taxes on Dividends
Here is a split up how much tax you could potentially pay on dividends. Income tax rate will be applied to ordinary dividends and capital gains rate will be applied to qualified dividends.
If you’re a student earning less than $39,376 in a year, you virtually pay zero taxes on your qualified dividends.
DRIP – Dividend Re-Investment Plan
Instead of trying to give long details, I’ll explain this through a simplified concept.
Say you have $10,000 earning a fixed 3% dividend yield every year and you do not contribute to this portfolio. At the end of the first year you’d get $300. If you re-invest those dividends (M1 Finance does it automatically), you can buy more shares of stocks that will earn you the 3% (assuming constant and not changing).
In 25 years, you’d effectively have a net value of $20,938 and that’s only from dividend re-investment from that original $10,000 (also ignores market gains/losses).
Now imagine if you started contributing $500 every month for the rest of your life, do not cashout any dividend until after 25 years and also made the following assumptions.
Lets say you are a 25 year old now and keep re-investing the earned dividends until you’re 50, the first payment you receive at age 51 will be $8,771 and will only grow from there.
Becoming a Millionaire
Not only does your portfolio grow (assuming all goes to plan), it generates exponential wealth the longer you are investing and that is the true power of compound interest.
If you’d like to play around with these numbers, here’s a useful link:
My Portfolio Update
This week’s dividend payouts – income I did not have to actively work for. I did not change my portfolio, just funded it and received dividend payouts.
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If you’d like to check out my portfolio, feel free to click the link below:
If you’d like to start investing using the same platform as I am – M1 Finance – feel free to open your free account and fund it to receive $10.