Why Are People Afraid of Dividend Stock Investing?

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When it comes to the financial independence community, I feel that investing in dividend stocks (as opposed to index funds) gets a bad rap.

Too often I hear complaints that earning dividend income is not worth it because of the tax implications.

Some of those concerns are certainly valid. For example, an individual who doesn’t fully optimize their income is certainly subject to paying more money in taxes.

In addition … high income earners don’t have as many tools available to fully optimize their dividend income. But they don’t have many tools to optimize their W-2 income either.

Personally, I feel that many people on the path to financial independence miss the potential for earning dividend income.

Every situation is different and what works for one family may not work for another.

But in our situation, building a dividend income stream is a good idea and part of our path to financial independence.

And it doesn’t hurt we probably won’t pay any federal taxes this year (2018) or next (2019) from these dividends either.

How to Earn Dividend Income While Paying $0 in Federal Taxes

Building a Dividend Income Stream

Before we get too far on this topic, I want to point out that I am only referring to investing in taxable brokerage accounts.

My wife and I purchase shares of dividend stocks in two main brokerage accounts – one is my Robinhood account and the other is a joint Fidelity account. Any dividend income or capital gains earned from assets in both of these accounts are subject to being taxed.

Note – We are in the process of consolidating our taxable brokerage accounts into the Robinhood and Fidelity accounts listed above. At the time of this writing, we do have a few other accounts we are working to consolidate.

During the current year (2018), we expect to earn around $3,300 in dividends from taxable brokerage accounts.

The bad news is that this income will need to be reported on our annual tax return.

The good news is that the majority of that dividend income should be considered “qualified” … which means it is taxed at the capital gains rate (which is lower).

And depending on our income … those qualified dividends may not be taxed at all!

What are Qualified Dividends?

Qualified dividends are income that is taxed at the capital gains rate instead of the normal tax rate for regular income. The capital gains tax rates are lower than the W-2 income tax rates.

So as a dividend investor who is also focused on optimizing my taxes … I would prefer most of my dividend income to be considered “qualified”.

According to the IRS, in order to be considered a qualified dividend (for tax purposes) … the following requirements must be met –

  1. Dividends must have been paid by a U.S. Corporation or a qualifying foreign company.
  2. The dividends are not listed with the IRS under those that do not qualify.
  3. Holding period has been met on the required dividend.

For more information on the rules for qualified dividends, I strongly suggest reviewing the IRS Rules for Qualified Dividends.

For now … just know that the majority of our dividend income is from qualified dividends.

Our Qualified Dividend Income

Overall, the stock portfolio that my wife and I have built over the past decade … the majority of our dividends are “qualified”.

This means that most of our dividend income has met the 3 IRS rules listed above. Even more important … this means our dividend income (from taxable accounts) is taxed at a lower rate than my W-2 income.

For example, in 2017 we reported $2,484 in dividend income on our tax return. Of that amount, $2,248 was from qualified dividends.

That means 90% of our dividend income back in 2017 was taxed at a lower rate!

In terms of our portfolio … our real estate investment trusts (REITs) make up the majority of non qualified dividend income. This income ($238) was subject to a higher tax rate.

We fully expect the majority of our dividend income this year (2018) and next (2019) will be considered qualified and taxed at the capital gains rates.

What are the Capital Gains Tax Rates?

Just like with any tax rates … the capital gains rates fluctuate year to year. So it is a good idea to search out up to date information when reviewing your qualified dividend income taxes.

Here is a quick look at the capital gains tax rates for 2018 if you are “married filing jointly”. My wife and I file our taxes jointly as a married couple, which is why we have only included these tax brackets.

  • 0% Capital Gains Tax Rate = $0 to $77,200 of taxable income
  • 15% Capital Gains Tax Rate = $77,201 to $479,000 of taxable income
  • 20% Capital Gains Tax Rate = $479,901 or more of taxable income

This is only for reference to show how our capital gains and dividends are taxed at a lower rate compared to my W-2 income. Please ask a financial professional if you have any questions about how capital gains are taxed in your situation.

Looking at the rates above, if we can manage to keep our income below $77,200 … then our taxes on the qualified dividends will be 0%.

And that is just what we are planning to achieve in 2018 … pay $0 in federal taxes … even after earning dividend income.

Building a Tax Free Dividend Income Stream

I wanted to end this post with one final piece of motivation.

It certainly motivates my wife and I to continue building our dividend income stream and is something we will pass along to our children.

Based on the current tax law (this can change) … we could potentially earn $77,200 of qualified dividend income and not pay any federal tax.

Of course that would take a huge investment and me no longer earning W-2 income … or at least taxable W-2 income. But regardless if we earn $77,200 or $7,200 in dividends per year … there are ways to optimize our other sources of income to keep our taxes at $0.

For example, we still have the $24,000 standard deduction bucket that could be filled up with “other” income from a W-2 job or from bonds or a business or whatever.

Then we have other tools that could be used with our tax deferred accounts through my work like a 457b.

The bottom line is there are many tools we can leverage if need be to optimize our income. And the more passive it gets (i.e. dividend income) … the more freedom and flexibility we get.

If you are looking for a little more inspiration about building passive dividend income streams and optimizing them for taxes, check out this post on Financial Samurai.

What camp are you in when it comes to earning dividend income from taxable accounts?

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