When you invest in stock, you may receive periodic payments called dividends that the corporation that issued the stock elects to pay to its shareholders. Companies with steady profits sometimes choose to pay dividends as a means of attracting and retaining investment. Cash dividends are typically considered a form of taxable income, even if they are reinvested.
Dividend Tax Basics
Cash dividends fall into two general categories for tax purposes: ordinary dividends and qualified dividends. A qualified dividend is a payment received from a U.S. corporation and certain qualified foreign companies, where you meet a holding period requirement. You must have owned a stock for at least 60 days during the 121-day period that occurs 60 days before a stock's ex-dividend date for a dividend to count as qualified. The ex-dividend date is the point after which new shareholders are not entitled to receive the stock's next dividend payment. Qualified dividends are subject to a maximum tax rate of 15 percent, just like long-term capital gains. Ordinary dividends are dividends that do not meet the requirements to be considered for qualified dividends and are taxed at your normal income tax rate.
Investors can typically choose to automatically use cash dividends to purchase additional shares of stock or "reinvest." If you reinvent dividends in a stock or mutual fund, you still have to pay taxes on the dividends as if you actually received them in cash. If a dividend reinvestment plan lets you purchase additional shares of stock at a price below the current market price, the difference between the cash you invest and the fair market value of the stock counts as taxable dividend income.
Some companies pay dividends in the form of additional shares of stock, without the need to reinvest cash dividends. Stock dividends are generally not considered taxable income, with certain exceptions. If you have the option of receiving a cash dividend instead of stock or receive a stock dividend as a preferred shareholder, you have to pay taxes on the fair market value of the stock dividend.
Certain types of retirement accounts, like 401(k) plans and individual retirement accounts, let investors defer taxes on gains until the time of withdrawal. Investment gains include capital gains, interest and dividends. This means you don't have to pay taxes on reinvested dividends in a tax-deferred account: instead you include funds you withdraw from the account in your normal taxable income.