Despite the fact that earning dividends requires no active participation on the part of the shareholder, dividends do not meet the criteria for passive income as outlined by the Internal Revenue Service (IRS). Being considered passive income is beneficial as it incurs a capital gains tax, which is much lower than tax rates on ordinary income. Ideally, an investor would prefer to be taxed at a capital gains tax rate.
Depending on how long you have owned your stock and where the corporation that issues it exists, however, your dividends may be considered qualified and could be taxed as capital gains as opposed to ordinary income.
Key Takeaways
- Dividends are ways to distribute profits to shareholders.
- Dividend-paying stocks allow shareholders to generate a regular stream of income.
- Passive income is money generated from rental properties or through a business in which the taxpayer doesn't have an active role but does have a financial interest.
- Ordinary dividends are not considered passive income and are taxed as ordinary income by the IRS.
- Qualified dividends are taxed at the more favorable capital gains rate.
What Are Dividends?
Dividends come from a company's retained earnings. They specifically come from unappropriated retained earnings. Unappropriated retained earnings are the portion of retained earnings that have not been earmarked for use for specific business purposes, such as buying new machinery.
Some investors pick stocks based on their dividend payout. Dividends allow investors to earn income on a regular basis. Some stocks may not be growth value options, but if they pay dividends, they provide their benefit in that manner.
Dividends are a way for publicly traded companies to redistribute profits to shareholders as a reward for their investment. Though dividend payments are not mandatory, many companies choose to issue them to illustrate their profitability and encourage additional investment. Dividends are paid either in cash or in additional shares of stock, and depending on the company, are paid at different intervals; sometimes quarterly, bi-annually, or annually.
A company's stock is usually issued as preferred stock or common stock. Preferred stock has priority over common stock, meaning that preferred stockholders are paid dividends first. However, preferred stock does not contain voting rights, which common stock does. The more common stock an investor owns, the more influence they can have on a company.
Many older or retired investors prefer dividend stocks, particularly since higher-dividend-paying stocks are from successful, well-established companies. This provides a lower risk profile for investors who are in the late stage of their investing life.
Passive Income vs. Ordinary Income
Passive income is defined by the IRS as any type of income that can only be generated by rental activity or by a business in which you have a financial interest but do not play an active role. For instance:
- You earn passive income if you own a home that you rent out, any income that your renters pay to you is considered passive income. This includes any fees you may charge.
- The only other way to create passive income is to bankroll a business in which you do not actively participate. In this case, you would be a silent partner.
Ordinary income is any form of income earned by a taxpaying entity that can be taxed at ordinary tax rates. This means that any money you earn from an employer (salary, wages, tips, bonuses, commissions, etc.) and royalties are considered ordinary income. Short-term capital gains, interest income, and unqualified dividends are also considered ordinary income.
Where Do Dividends Fit in?
Some professionals consider dividends to be a form of portfolio income and, therefore, passive income. But the IRS doesn't necessarily consider it as such, In fact, the agency has many rules about what is and isn't considered passive.
Because dividends do not always fall into one of the two categories described as passive income above, they may be considered ordinary income that would not qualify for capital gains tax. Some dividends can qualify for capital gains tax treatment if they are deemed qualified dividends.
Though most dividends paid by corporations or mutual funds are considered ordinary dividends, some may be considered qualified dividends. In these cases, your dividend income is subject to the capital gains tax rate rather than your income tax rate, which is higher.
To be considered a qualified dividend, a dividend must be paid by an American corporation or a qualified foreign entity. In addition, you must have held the stock for which the dividend was paid for at least 60 days within the 121-day period that ends 60 days prior to the ex-dividend date. For instance, if the ex-dividend date is Dec. 1, then you must have owned the stock for at least 60 days during the period between June 3 and Oct. 2.
What Is Passive Income?
Passive income is a form of income generated from sources other than an employer. This type of income can be earned from rental properties or from an enterprise in which a taxpayer has no active involvement, such as a limited liability partnership. Like other types of income, passive income is taxable. Passive income does not include money earned from dividends, royalties, interest, or annuities.
How Are Dividends Taxed?
The taxation of dividends depends on the category. Qualified dividends, which are paid by public companies to individuals who own common stock, are incur capital gains taxes. This means that they are taxed at 0%, 15%, or 20% based on your taxable income. Ordinary dividends, on the other hand, are taxed at your regular income tax rate. This type of dividend represents a share of the company's profits that is passed on to shareholders on a regular basis.
What Falls Under Ordinary Income?
Ordinary income is any type of income that can be taxed at ordinary tax rates. This type of income includes any money earned through an employer, such as salaries, tips, bonuses, and commissions. Other types of ordinary income include royalties, short-term capital gains, interest income, and unqualified dividends.
The Bottom Line
Certain types of passive income qualify for capital gains tax, which is a lower rate than ordinary income tax. This makes it more attractive. But dividends do not fall under the passive income category as defined by the IRS, so they are taxed at regular income tax rates. The only exception is if the dividends are qualified dividends by meeting certain criteria. In this case, dividends are held to capital gains tax.
