02 Mar Understanding How to Re-invest Portfolio Income
by Curtis Hearn
When investments earn income, that’s good news, right? But what should investors do with this income?
The decision whether to reinvest income gained from a portfolio — or to cash out — usually comes down to tax considerations. There are different types of investment income: dividends, capital gains and interest income, for example. If your investments earn cash dividends, they tend to fall into two general tax categories: qualified dividends and ordinary dividends. Qualified dividends are taxed as capital gains, and ordinary dividends are taxed as ordinary income.
Below, we discuss why this taxation is crucial for making informed decisions about what to do with your portfolio income, and provide some guidelines for how to maximize your earning potential from investments.
Taxes on Qualified Dividends
Qualified dividends are dividends that meet the following requirements:
- The dividend must have been paid by a US company or qualifying foreign company
- The dividends are not listed by the IRS as unqualified (more on that below)
- The required holding period of the asset has been met, typically more than 60 days during the 121-day period that starts before the ex-dividend date.
These dividends are taxed at the same tax rates as long-term capital gains. 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. Gains are realized only when the stock or asset has been sold for a profit after holding it for a certain period of time. The capital gains tax rate is generally lower than the income tax rate.
Tax is generally not paid until after a gain is realized or when the asset is sold. If, for example, investors with a large stock portfolio notice that the individual prices of the assets have increased, they will not pay capital gains taxes until the stocks are sold — hopefully at those higher prices for a nice profit.
Below are the 2021 tax rates on qualified dividends by income level:
- 15% for
- single taxpayers with an income of $40,401 to $445,850
- married couples filing jointly with an income of $80,801 to $501,600
- heads of household with an income of $54,101 to $473,750
- 20% for
- single taxpayers with an income of $445,851 or more
- married couples filing jointly with an income of $501,601 or more
- heads of household with an income of $501,601 or more
Taxes on Non-qualified Dividends
Non-qualified dividends are taxed as ordinary income and don’t qualify for the more favorable tax treatment of qualified dividends. There are many reasons a dividend might be non-qualified, including not holding it for a long enough time period or an investment that comes from an unapproved source such as dividends paid by real estate investment trusts, master limited partnerships, employee stock options, money market accounts and more.
A wealth advisor can help you understand this distinction, as the rules can be complicated. Even those who own large bond portfolios might find themselves paying the (higher) income tax rate when those bonds are sold at higher prices.
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 because as mentioned above, the gain is “realized.”
Some companies modify their dividend reinvestment plans (DRIPs) by allowing shareholders to purchase additional shares of stock at below-market prices; in these cases, the difference between the cash reinvested and the fair market value (FMV) of the stock is taxed as ordinary income.
To avoid a cash situation, some companies instead pay dividends to their shareholders in the form of additional company shares, known as stock dividends. This is an advantage to both parties, as stock dividends are generally not taxable until the stock is sold (realized) and more of the company’s stock is held by existing shareholders. This makes stock dividends a generally better option for reinvesting portfolio gains than cash dividends. However, there is one important caveat here. If the company gives investors the choice between stock or cash dividends, the investor is still taxed even if he or she chooses stock dividends.
Type of Investment Accounts
The tax consequences of portfolio income and dividends also depends on the type of investment account an investor owns.
For example, investors would not owe taxes on dividends from stocks held in a retirement account like a Roth IRA or 401(k), or a college savings plan like a 529 plan or Coverdell ESA. However, they may owe taxes on dividends earned by individual stocks held in a regular, taxable brokerage account.
Understanding how to best leverage your portfolio income can take a considerable amount of time and expertise. That’s why when it comes to the decision to reinvest portfolio income, investors with large, complex portfolios should seek the advice of a wealth advisor to help them navigate and select the most profitable — and tax-advantaged — strategies to do so. Reach out to the team at Gratus Capital today to learn more about putting your income to work to achieve your financial goals!