Dividends, those periodic payments made to shareholders who buy and hold preferred stock in certain publicly-traded companies, are often praised by value investors and financial planners as being essential tools for building wealth. Dividends can be easily found in investment vehicles such as mutual funds and managed investing accounts.
To many blue chip investors, dividends are the closest they can get to deriving regular income from their stock portfolios, and this is a view that is shared by the United States Internal Revenue Service (IRS). Dividends are treated just like regular income, which means that some U.S. taxpayers could expect to be taxed as much as 40 percent on their dividends. The tax on the underlying stocks that generate dividends can be offset to a certain extent by the rules that govern capital gains taxation; however, such is not the case with dividends.
Since dividends can be taxed at a high rate based on an investor's tax bracket, it would make sense to find a good strategy for them, and reinvesting them to purchase more stock is a popular strategy. It really does not matter if the dividends are used to purchase shares of the same company; the tax liability will not really be alleviated, but at least the prospect for long-term gains is improved. This strategy can be made easier with dividend reinvestment programs (DRIPS), which provide investor with seamless fractional purchases of stock. In the end, however, investors are simply purchasing more stock, which means that they should expect to pay taxes.
The best bet for investors who wish to minimize their tax liability on dividends is to make Individual Retirement Accounts (IRAs) a significant portion of their portfolios. What these financial planning and investing plans accomplish is that they allow a significant accumulation of income and assets at very low tax rates for the purpose of retirement. The only time IRA participants have to worry about taxation is when they intend to make a withdrawal that is not within their retirement plans.
It is important to note that some credit unions call the interest they pay on deposits “dividends,” which are also taxable but at a different rate than stock dividends.