At a very superficial level, growth stocks have greater tax advantages than dividend stocks in that you only pay capital gains tax once you sell the stock. Capital gains taxes are lower than ordinary income tax rates. Ordinary dividends are considered income, so you are expected to pay income taxes for them, even if you sell all your dividends to reinvest.
However, that simplistic overview doesn’t tell the full story. For example, there are potential workarounds for dividend taxes, and there are qualified dividends that are taxed at the capital gains rate. Depending on your income in retirement, you may be able to minimize or even eliminate your capital gains taxes as well.
For the 2022 tax year, single filers making $41,675 or less or joint filers who make less than $83,350 will be exempt from capital gains. Some retirees can make use of investment and tax planning strategies that allow them to stay below those income thresholds.
The length of time you hold an equity before selling will also affect the tax rate you are required to pay. Short-term gains, or gains from stocks sold within the first year of ownership, are separate from long-term capital gains, or gains made from the sale of stocks you’ve held for more than a year.
Long-term capital gains rates are 0 percent, 15 percent, or 20 percent, while short-term capital gains are taxed like regular income.
Retirement Savings Accounts or Other Tax Advantaged Investment Plans
One way you can avoid taxes on either the sale of growth stocks or dividend stocks is with certain tax advantaged investment accounts, like Roth IRAs or 529 Plans. In both cases, you can trade and reinvest equities in the accounts, and reinvest dividends, without being taxed.
Investors using either Roth IRAs or 529 Plans should educate themselves on the rules governing each. You’ll only enjoy the tax advantages of a 529 Plan if you spend the funds on qualified education expenses, and disbursement rules must still be followed to avoid additional taxes on Roth IRA gains. However, with Roth IRAs, your contributions have already been taxed, which means they can be withdrawn at any time without additional taxes or penalties.
Qualified Dividends vs. Ordinary Dividends
Ordinary dividends are essentially considered ordinary income by the IRS and are taxed at your ordinary income tax rate. A qualified dividend is taxed at your capital gains rate. The ordinary income tax rate is higher than the long-term capital gains tax rate, so it’s preferable to pay the long-term capital gains rate if possible. Some people, especially retirees who are living on a reduced income, can completely avoid capital gains taxes and therefore don’t pay taxes on qualified dividend income.
Whether dividends are qualified or ordinary may also be affected by the short-term and long-term gains rule, although the timelines are a bit complicated. For example, dividends may be considered qualified if you’ve owned a domestic common stock for at least 60 days during a 121-day period beginning at least 60 days prior to the ex-dividend date. The timeline is slightly more stringent for preferred shares (held 90 days during the 181 days beginning 90 days prior to the ex-dividend date.)
Essentially, you can’t buy a stock right before the ex-dividend date and expect the dividend to be qualified.
There are also different rules for different types of investments. REIT (Real Estate Investment Trust) dividends tend to always be classified as ordinary regardless of how long you’ve invested in the fund.
Several other types of dividends are almost always considered “ordinary,” including things like foreign equities, employee stock ownership plans, money market funds and interest-paying bank and savings accounts.
Not Sure Which Investment Options Can Best Help You Maintain Supplemental Income in Retirement While Minimizing Your Tax Burden?
The team at Fullerton Financial Planning combine expertise in investment management, retirement planning, estate planning and taxes to develop comprehensive plans for our clients. You should consider speaking with an experienced investment advisor before making potentially life-altering decisions about your retirement investment portfolio.
Call us at (623) 974-0300 to speak with a financial advisor today. We have two locations: Tempe and Peoria, AZ.
