Dividends and Taxes: Understanding Form 1099-DIV

Dividends are distributions of earnings from a company to its shareholders. These distributions can be in cash or in the form of additional shares. If the stock that issued the dividends is held within a taxable brokerage account, those dividends will be taxable income to you in the tax year the dividend occurred. Generally, dividends are reported to you and to the IRS on the Form 1099-DIV or part of a consolidated 1099 that includes all tax information within a single document.

The tax code has its own way of talking about dividends that can sometimes be confusing. From a tax perspective, all dividends are initially considered "ordinary dividends." Then dividends get subdivided into two groups: qualified dividends and nonqualified dividends. No matter the type of dividend, they are all considered current year taxable income—unless the stock is held within a tax-advantaged account like an IRA or 401(k).

Qualified dividends get their name because they can qualify for a special lower tax rate. There are several requirements that must be met for a dividend to be considered qualified, such as:

• The stock issuer must be a domestic company or a qualified foreign corporation. 
• You must own the stock for more than 60 days during the 121-day period that starts 60 days before the ex-dividend date. 
• For some preferred stocks, the shares must be held for longer than 90 days out of the 181-day period that begins 90 days before the ex-dividend date.

If the dividend is qualified, it'll generally be taxed at the lower long-term capital gains tax rates, depending on your federal tax bracket of 0%, 15%, or 20%. Fortunately, the issuers of the Form 1099-DIV are required to report to you if the dividends are qualified or not. However, if you're not sure if a dividend is qualified, we recommend working with a tax advisor to properly report that income on your tax return.

Nonqualified dividends are basically any dividend that is not a qualified dividend. Nonqualified dividends are taxed at the higher ordinary income tax rates, which range from 10% to 37% for federal taxes.

Dividends can also be subject to other taxes. If your modified adjusted gross income is over certain levels, the federal 3.8% net investment income tax could also apply. And depending on where you live, state taxes could also be collected on that dividend income.

When you receive your Form 1099-DIV, the dividend income may appear in two locations on the form, and it may look like it’s being double reported. The reality is, yes, the income is being double reported—but you'll only be taxed once on the dividends. On the 1099-DIV, all dividends are reported on line 1a as "ordinary dividends." But some of these ordinary dividends may be qualified dividends and taxed at a lower tax rate; if that's the case, those show up on line 1b. 

For example, if you had $2,000 of dividend income, that entire amount would be an ordinary dividend reported on line 1a of the 1099-DIV. If $1,500 of that income was from qualified dividends, that amount will appear on line 1b. When you put that information into your tax return, it tells the IRS that you had total dividends of $2,000, but $1,500 of these dividends qualified for a lower tax rate, leaving only $500 in dividends subject to the higher tax rates.

Another item that tends to confuse people is a return of capital or a "nondividend distribution." These distributions look like dividends (appear on line 3 of the Form 1099-DIV) but are generally a nontaxable return of capital from the company. These distributions lower the cost basis of your shares, which means when you sell that stock in the future, you could have a larger capital gain to recognize. But be aware, if the basis of your shares is reduced below $0, you may have to realize taxable income from these distributions. 

For example, let's say you paid $10,000 for a security, and that security makes a payment of $500. Later that year, the issuer gives notice that this payment will be classified as return of capital (a.k.a. a nondividend distribution) for taxation purposes. Instead of claiming that payment as income, the payment amount is used to decrease your cost basis to $9,500. In this scenario, the tax liability is basically deferred until you sell the shares.

Another situation that can arise is when a broker sends out an updated 1099-DIV during tax season. Many times, this is due to the dividend issuers providing corrected information about how the dividends should be classified. 

For example, a company initially stated that all dividends paid are nonqualified, which means they're taxed at ordinary income tax rates. Later, they reclassify some of those dividends as qualified, which means some of that income will be taxed at a lower tax rate. If you have already filed your tax return, you may have to file an amended return to properly account for this change.

Dividends are an important part of many investors' portfolios, but with any source of income comes a potential tax liability. That's why we recommend working with a tax professional or wealth advisor to ensure your dividend income is earned in the most tax efficient way, leaving you more money to re-invest or to provide for your living expenses.