Paying Tax on Dividends

The bad news: You must include dividends in your taxable income when you file your income tax return. The good news: If they're qualified dividends, you will pay the lower capital gains tax rate. In general, qualified dividends refer to those paid by domestic corporations and certain foreign corporations in which you have held stock for at least 61 of the 120 days surrounding the stock's ex-dividend date. As of 2012, the highest tax rate on capital gains is just 15 percent.

Your brokerage should send you a Form 1099-DIV reporting the dividends that you received. On this form, the total amount of dividends that you receive is listed in box 1a and the amount of the qualified dividends is reported in box 1b. You must report each source of dividends on Schedule B and then identify if any of the dividends that are qualifying dividends. Then, copy the totals over to either Form 1040 or Form 1040-A. You may not use the shorter Form 1040-EZ.

Some companies and mutual funds will automatically reinvest the dividends in either company shares or mutual funds if you request it. Even though you don't receive the money, you still must include the reinvestment in your taxable income because you made the choice to reinvest the money. Don't forget to keep track of how much you reinvest each year because that increases your basis. When you sell your shares, you will be able to offset more of your gain with the amount you paid for the shares.

If you receive additional stock in the company as a dividend, it may qualify as a nontaxable stock dividend. To qualify, all shareholders must receive the same ratio of shares: For example, a company might pay a stock dividend of one share for every 10 shares owned. In addition, you may not have the option to receive cash instead of shares. If you do, the IRS treats you as having received the cash and reinvested it in shares, similar to a dividend reinvestment program.