Not much in the world of investment is guaranteed. But, as they say, two things in life are guaranteed — death and taxes.
When it comes to investing, it’s essential to understand the tax consequences of various investing decisions. Whether it’s capital gains income vs. ordinary income, long-term capital gains vs. short-term capital gains, or the critical differences between qualified dividends and ordinary dividends, these distinctions are important.
In this article, we’ll look at qualified dividends vs. ordinary dividends and what action you can take to minimize your tax bill.
Ordinary and Qualified Dividends: What’s the Difference?
When stocks pay dividends, that dividend income must be reported on your tax return — either as qualified or nonqualified income. Nonqualified income is also known as ordinary income. While this distinction might not appear significant, it has major tax consequences.
Why? Because the difference to your bottom line can be quite substantial.
All things considered, nonqualified dividends are typically taxed at your marginal tax rate, which depending on how much you earn, could be as high as 39.6%. Qualified dividends that check a variety of criteria boxes are taxed at the lower long-term capital gains tax rate, which could be 15% or 20% as of March 2021. And in some situations, for investors in lower income tax brackets, qualified dividends may not be taxed at all.
At the end of every year, you receive a form called a 1099-DIV from any banks or brokerage firms that paid you dividends. The IRS receives the same information about dividends paid and received.
On the Form 1099-DIV, you’ll see box 1a containing ordinary dividends and box 1b containing qualified dividends.
Ordinary dividends are treated like ordinary income — just like income you earn at work — and are taxed in the same way.
Investors can assume that dividend payments are ordinary unless the entity paying the dividend indicates otherwise.
There are also some dividend payments that will always be considered ordinary income. These include:
- Dividends from tax-exempt organizations like real estate investment trusts (REITs) and master limited partnerships (MLPs)
- Dividends paid by your employee stock ownership plan (ESOP)
- Special one-time dividends
- Any dividends associated with hedging activities like short sales, put and call options, or payments received in lieu of dividends
All of the above mentioned investments and distributions will be taxed at the ordinary federal income tax rate.
A qualified dividend is exactly what it sounds like. It’s dividend income that “qualifies” for favorable treatment.
Qualified dividends are taxed in the same way that proceeds from long-term capital gains are taxed. This rate is much lower than the ordinary income tax rate. The capital gains rate will be 20%, 15%, or 0%, depending on your tax bracket, whereas the tax rate for ordinary income can be as high as 37%.
Qualified dividends must meet certain criteria. First, the dividends must be paid by a U.S. corporation or a qualified foreign corporation. A qualified foreign corporation is one that meets one of these conditions:
- It has readily tradable stock on a registered exchange.
- It is incorporated in a U.S. territory.
- It is covered by an income tax treaty with the United States
Second, the investor must meet the relevant minimum holding period requirement:
- For common stock, the investor must have held the underlying security for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date.
- For preferred stock, the investor must have held the shares for at least 91 days out of the 181-day period that starts 90 days prior to the company’s ex-dividend date.
3 Common Questions About Qualified Dividends
Below are a few questions investors most often ask about qualified dividends.
1. What’s the purpose of having two types of dividends and treating them differently for tax purposes?
As previously discussed, qualified dividends are taxed at the capital gains tax rate. And non-qualified or ordinary dividends are taxed as ordinary income, which results in you, the investor, paying more taxes.
Allowing more favorable tax treatment for qualified dividends incentivizes companies to reward long-term shareholders with higher dividends. The favorable treatment for qualified dividends also incentivizes the shareholder to hold onto those shares for longer periods of time in order to collect dividend income.
2. How can I make sure the dividends I receive will be treated as qualified dividends instead of ordinary dividends for tax purposes?
Because the potential for major tax savings is quite important, especially in retirement, this is a great question.
But unfortunately, there is not much you as an investor can do to impact the tax treatment of your dividends other than hedging your dividend stock portfolio toward stocks that pay a qualified dividend. This strategy can make a significant difference when it comes to how much wealth you can build before you’re ready to harvest the fruit of all your investing efforts.
To do this, the action you can take is to hold onto your dividend stocks for the minimum holding period. In other words, adopt the mindset of a long-term investor.
When it comes to minimizing your tax bill, that really is the best advice.
Dividend income is a powerful way to achieve long-term financial success. When it comes to both financial success and minimizing taxes, the patient investor wins in the end. When you buy solid companies and hold them while collecting dividend income as those companies scale and build momentum, you’ll be growing your dividends along the way.
3. Which is more important: the tax advantages of qualified dividends or a portfolio with high yields?
Federal income tax filing day can be a stressful day.
Smart tax planning can and should certainly play a large role in your investment strategy. Too often, however, becoming fixated on reducing taxes can cause investors to take their eyes off the prize and lose sight of the real goal — to earn as much as possible.
If you can produce better-than-average returns by adding some stocks that pay exceptionally high ordinary dividends into your portfolio, go for it. (Investors Alley’s Dividend Hunter newsletter can show you which high-yield picks to invest in.)
The bottom line here is to compare your return potential after taxes.
Playing the Long Game
Qualified dividends provide a tax-efficient source of investment income that can be especially attractive for retired investors. As long as the dividend is being paid by a U.S. or a qualified foreign corporation and you own the stock for the minimum holding period, you’ll be able to pay a lower tax rate and keep more of your returns.
Investors who purchase shares of high-quality dividend stocks can help secure a financially stable retirement for themselves. You’ll have money to pay the bills and stay retired. To learn about three dividend stocks you should buy and hold forever, subscribe to Investors Alley “Dividend Hunter” newsletter.