Understanding the categories of dividends is key to making an informed decision on whether to reinvest or cash out for tax purposes. Cash dividends tend to fall into two broad tax categories: qualified dividends and ordinary dividends. Ordinary dividends are taxed as ordinary income. Many critics decry this system as "double taxation," since corporate profits are taxed when earned and taxed again when distributed as income.
Taxes on Qualified Dividends
Qualified dividends, which must meet certain requirements, are instead subject to lower capital gains tax rates. A capital gain is an increase in the value of a capital asset, such as real estate or an investment, above the amount paid for the asset.
There is a difference between realized and unrealized capital gains. A gain is not realized until the stock or other asset has been sold. Tax is generally not paid until after a gain is realized. There are exceptions to this rule, however.
The amount of tax paid on a qualified dividend depends on the income of the recipient. For those in the 10 to 20% income bracket, there is no tax owed on a qualified dividend as of 2015. This applies only if the dividend income does not take the recipient out of that tax bracket. The tax rate for the middle income brackets is 15%. For those in the 39.6% tax bracket, the taxation rate for qualified dividends is 20%.
Taxes on Ordinary (Non-Qualified) Dividends
The Internal Revenue Service (IRS) defines a number of dividends that are not qualified; these dividends are taxed as ordinary income. Ordinary income also includes income received from wages, salaries, commissions and interest income from bonds. Ordinary income can be offset with standard deductions, while income from capital gains can only be offset from capital losses.
Capital gains distributions are not qualified dividends. Any dividends paid on deposits with credit unions and certain other financial institutions are not qualified. Any dividends from a non-profit corporation or other tax-exempt organization are not qualified. Dividends paid by a corporation on securities that an employee holds in an employee stock ownership plan maintained by the corporation are defined as non-qualified. Dividends on shares of stock where the holder is required to make related payments are not qualified. Dividends from foreign corporations are generally not qualified.
Taxes on Dividend Reinvestment
Reinvesting dividends is the process of automatically using cash dividends to purchase additional stocks of the same company. If you choose to reinvest your dividends, you still have to pay taxes as though you actually received the cash. Some companies modify their dividend reinvestment plans (DRIP) by allowing shareholders to purchase additional shares of stock at below market price; in these cases, the difference between the cash reinvested and the fair market value (FMV) of the stock is taxed as ordinary dividend income.
Some companies do not pay dividends to their shareholders in the form of cash, but rather in the form of additional company shares. Stock dividends are generally not taxable until the stock is sold. This exemption is forfeited if the company allows the investor to choose between stock or cash dividends, in which case the investor is taxed even if he or she chooses stock dividends.
There is also a less common type of tax-free dividend account that companies can create for their shareholders known as a capital dividend account (CDA). With this account, capital dividends come from paid-in capital rather than retained earnings.
The rules regarding the taxation of dividends is briefly discussed in Internal Revenue Service (IRS) Topic 404, though Publication 550 defines qualified dividends and Topic 730 discusses capital dividends.