Think reinvested dividends aren’t taxed? Think again.

Tyler Kert
Tamarack Wealth Management

Dividend stocks have been making a comeback in popularity as market volatility has people looking for something a little more predictable. They offer income and growth potential that can add stability and long-term performance to your investment portfolio.

Dividends provide reliable income, often on a quarterly basis. For retirees, this can mean a steady cash flow to supplement Social Security or pension benefits. For younger investors, dividends can be reinvested to buy more shares, compounding your returns over time. This “dividend reinvestment” strategy can turn modest investments into significant wealth over the years, especially when combined with the natural growth of the stock market.

Dividend-paying companies also tend to be more stable and mature businesses. Start-ups don’t typically pay dividends. Firms that regularly pay dividends are usually well-established with solid financials and consistent profits. But while dividend yields can provide steady income, there’s one silent partner who always wants a cut: Uncle Sam.

Whether you're an income investor or just dabbling in dividend-paying stocks, it’s important to understand how dividends are taxed because your actual return might be very different after taxes.

Dividends in a retirement account (IRA or Roth IRA)

Here’s the good news: dividends earned inside an IRA or Roth IRA are not taxed when they’re paid. In a traditional IRA, you don’t pay tax on the dividends as they come in, but you will pay ordinary income tax when you take money out of the account in retirement. In a Roth IRA, you won’t pay any tax on the dividends or the withdrawals because you already paid the tax before you put the money into the account. 

That means retirement accounts can be a great place to hold dividend-paying stocks if you’re trying to grow your investments tax-efficiently. If you are holding all your dividend stocks in a Roth or 401(k), you don’t need to worry about how they are taxed.

Dividends in a taxable brokerage account

In a taxable account, things get more complicated. Not all dividends are treated the same. Some are qualified, and others are not, and the difference matters. Not only that, there is a common misconception that reinvested dividends are tax-exempt. This is not true.

Qualified dividends benefit from the lower long-term capital gains tax rates, which could be 0%, 15%, or 20% depending on your income. To be classified as qualified, the dividend must be paid by a U.S. corporation or a qualifying foreign company, and you must hold the stock for more than 60 days during a specific 121-day window around the ex-dividend date. That means if you sell the stock too quickly, the dividend might be reclassified as nonqualified. It sounds complicated, but the takeaway is that holding a dividend stock for longer than two months will usually get you a preferential tax rate. 

Nonqualified dividends, on the other hand, are taxed as ordinary income. That’s the same rate you pay on your wages or salary, which for many investors could be significantly higher. These dividends are often paid by investments like real estate investment trusts (REITs), certain foreign stocks, and other specialty securities.

Reinvested dividends are taxed

Here’s the common misconception: reinvesting dividends doesn’t get you out of taxes. I’ve had to explain this to many clients who don’t realize that reinvested dividends are taxed. They often don’t even think about it until the dividends are driving them up into higher tax brackets. 

Even if you automatically reinvest dividends to buy more shares through a dividend reinvestment plan (DRIP), the IRS still counts those dividends as income. So, whether you pocket the cash or reinvest it, you still have to pay the tax.

Bottom line

Dividends can be a great part of your investment or retirement strategy but it’s the after-tax return that really matters. If you’re investing for income, make sure you understand whether your dividends are qualified or not, and use retirement accounts to avoid unnecessary taxes. Don’t assume reinvesting makes the taxes disappear.

Dividend taxation is yet another reason that it is critical to follow a tax-smart financial plan. If you have dividends in taxable accounts when you could be holding them in your qualified accounts, you might be losing thousands of dollars a year in avoidable taxes.

If you’re not sure whether your portfolio is tax-efficient, that’s where we can help. As financial advisors and CPAs, we can help you align your investment strategy with your tax situation so you can keep more of what you earn.

This material is for informational purposes only and does not constitute financial, investment, or tax advice. Please consult your tax advisor or financial planner to discuss your specific circumstances before making any decisions.

Tyler Kert, a licensed financial advisor and CPA, provides financial planning and tax consulting services at Tamarack Wealth Management in Cashmere, WA.