Stocks that pay dividends are some of the best opportunities in investing. Not only do stocks have the potential to grow, but you earn dividends as well. Win-win, right? Unfortunately, like most investments, dividends are also taxable. This could lead to a painful surprise from Uncle Sam and could make some tax headaches for you come April. You can avoid or lessen the tax burden on dividends by planning ahead, being careful and considering your investments. Here are some ways to plan for and mitigate how much in taxes you pay on dividends. (For more, see: The Power of Dividend Growth.)

Better to Pay Taxes Than Avoid Investing

First off, don’t let the fear of paying taxes deter you from investing in dividend-paying stocks or other asset classes. Most of investing comes with the possibility of paying taxes. It's just another price to pay for potentially earning a much higher return than if you'd kept the money in a savings account or a certificate of deposit (CD) in the current low interest environment. (For more, see: Dividends Still Look Good After All These Years.)

The first thing to do is find out if your dividends are qualified or unqualified. Unqualified dividends are taxed as ordinary income, so they’re taxed at a much higher rate. Try to hold the dividend-producing shares as long as you can to ensure that you won’t pay higher tax rates on them. Dividends are typically taxed at lower rates, so always try to hold them as long as possible. (For more, see: How Dividends Work for Investors.)

Setting Up a DRIP

Instead of taking your dividends reinvest them. You can set up a Dividend Reinvestment Plan or DRIP. Drip plans allow investors to reinvest dividends into buying more shares in the stock each time a dividend is paid out. This is an effortless no-cost way to grow the amount of shares you have without buying more of them yourself. (For more, see: The Perks of Dividend Reinvestment Plans.)

One of the other benefits of a DRIP plan is that you don’t have to pay brokerage fees when you reinvest the dividends. Another less-known benefit is that the dividends can be used to buy portions or fractions of shares. Reinvesting dividends is also a dollar-cost-averaging strategy, which averages out the price at which you buy stock as it moves up or down over a long period. (For more, see: DCA: It Gets You In at The Bottom.)

How Dividends Are Taxed Differently

Certified financial planner (CFP) Peter J. Creedon, of Crystal Brook Advisors, said one of the best aspects of dividends is that they aren’t taxed like capital gains or ordinary income. That makes the potential tax sting that much less painful to bear. (For more, see: How are Capital Gains and Dividends Taxed Differently?)

“Dividends are usually taxed at a lower rate than ordinary income or interest (bond),” he said. “If your taxable income falls below the 25% tax bracket you may wind up paying 0% in taxes. The tax bracket at or above 25% but below 39.6% is normally taxable at 15%. If income falls in the 39.6% bracket or above the rate on a long term capital gain and qualified dividend is 20%.” (For more, see: Understanding How Dividends Are Taxed.)

If your adjusted gross income is more than $200,000 for people filing single or $250,000 for married couples filing jointly, you’ll pay an extra 3.8% tax on those dividends. Also, if you’re in the 39.6% tax bracket or higher you’ll pay the capital gains tax rate on dividends, which is 20%. Couples who make more than $450,000 or single people whose taxable income is $400,000 will find their tax rates for dividends higher than normal.

That means that dividends can be a great investment for people in lower tax brackets, who might not owe any taxes on their dividends. As always, make sure to verify your tax bracket and adjusted gross income before you make a decision. (For more, see: Your Dividend Payout: Can You Count on It?)

The Bottom Line

Just remember, even if you do end up owing taxes on your dividends, there are ways you can lessen the burden. Use the strategies mentioned above and you'll find that the tax burden you face won't be as bad. Plus, the earlier you start to plan, the more likely you can employ these methods to lower your tax burden. If you have trouble figuring out your specific tax situation, contact a certified public accountant (CPA) or CFP. A qualified financial advisor or tax expert may be able to show you other strategies you can employ to shave down your tax bill. (For more, see: How and Why Do Companies Pay Dividends?)

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