What Are Qualified Dividends, and How Do They Affect Taxes?

Dividend Investing
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What are qualified dividends? As the name suggests, a qualified dividend is a type of dividend that “qualifies” for favorable tax treatment. 

Dividend investing is an important part of any comprehensive investment strategy. Dividends are payments companies make to shareholders. Many of the highest-performing stocks are companies that pay dividends.

But when you receive those dividends, you’ll likely need to share the proceeds with the Internal Revenue Service. Dividend income must be reported on your tax return. The tax treatment depends on whether your payout is a qualified or a non-qualified dividend (also known as ordinary income). 

Because of the significant tax impact to your bottom line, understanding the difference between these types of dividends is quite important. In this article, we’ll look at both types and explore how to minimize your tax bill.

What Are Qualified Dividends?

Qualified dividends are those that “qualify” for favorable tax treatment. 

Qualified dividends are taxed just like proceeds from long-term capital gains. And this rate is significantly lower than the ordinary income tax rate. The capital gains rate will be 20%, 15%, or 0%, depending on your tax bracket. On the other hand, the tax rate for ordinary income can be as high as 39.6%. 

There are several criteria a dividend must meet in order to be considered qualified and receive this preferential tax treatment. 

To start, the dividend needs to be distributed by a U.S. corporation or a qualified foreign corporation. A qualified foreign corporation must meet one of these conditions:

  • Readily tradable stock on a registered exchange
  • Incorporated in a U.S. possession or territory
  • Covered by an income tax treaty with the United States

Then, you must have owned the dividend stock for the relevant minimum holding period requirement:

  • For common stock: More than 60 days during the 121-day period beginning 60 days before the ex-dividend date
  • For preferred stock: At least 91 days out of the 181-day period that starts 90 days prior to the company’s ex-dividend date

To further understand what qualified dividends are and how to qualify for the lower rate, it’s also important to examine what qualified dividends are not. And so we’ll now look at non-qualified or ordinary dividends.

What Are Ordinary Dividends?

When it comes to ordinary dividends, they are treated like ordinary income. Ordinary income is income you earn at work.

How much you earn in a given tax year determines how much you pay on ordinary income. Ordinary dividends are taxed at a marginal tax rate, which depending on your tax bracket, could be as high as 39.6%.

Below are a few types of dividend income that will always be considered ordinary income:

  • Special one-time dividends
  • Dividends paid by your employee stock ownership plan (ESOP)
  • Dividends from hedging activities like short sales, put and call options, or payments received in lieu of dividends
  • Dividends from tax-exempt organizations like master limited partnerships (MLPs) and real estate investment trusts (REITs)

All of the investments and distributions above receive ordinary federal income tax treatment.

Understanding the Difference

You might be wondering at this point, “Why does the IRS make everything so complicated?” You’re certainly not alone. And we are not going to promise a complete answer to that question.

But we’ll say this: By providing favorable tax treatment for qualified dividends, shareholders have a reason to be longer-term investors. And this incentivizes companies to reward those longer-term shareholders with higher dividends.

Getting the Taxes Right

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If you’re wondering how you’ll ever figure out which type of dividend income you’re receiving, again, you’re not alone. It’s essential to understand the tax consequences of your investing decisions since the potential tax savings is huge, and especially important when planning for retirement. 

Whether it’s capital gains income vs. ordinary income, long-term capital gains vs. short-term capital gains, and of course qualified dividends vs. ordinary dividends, these distinctions are important.

Qualified dividends that meet the above-mentioned criteria are taxed at the lower long-term capital gains tax rate, which could be 15% or 20% as of April 2021. In some cases, qualified dividends received by investors in lower income tax brackets might not be taxed at all.

The criteria discussed earlier in the article might seem confusing, but luckily, the IRS is on your side in this one.

At the end of every year, the IRS mandates that companies report dividends paid. You’ll receive a form called a 1099-DIV from your bank or brokerage firm that paid you the dividends. It’s your responsibility to then report that dividend income. The IRS, of course, receives the same information about dividends paid and received.

On Form 1099-DIV in box 1a, you’ll see ordinary dividends, and in box 1b, you’ll see qualified dividends. This makes preparing your return quite a bit easier.

What Action Should I Take?

All things being equal, a qualified dividend is likely to put significantly more money in your pocket than a similar non-qualified dividend. So hedging your dividend stock portfolio toward stocks that pay a qualified dividend might be something to consider. 

This strategy may alter your trajectory when it comes to building wealth. 

Another strategy to minimize your tax bill is to hold onto your dividend stocks for the minimum holding period. Try to play the long game and become a long-term investor. 

Whatever you do, be sure to balance your investment strategy between tax planning and earning as much as possible. Investors sometimes become hyper-focused on minimizing their tax bill and lose sight of the ultimate goal, which is earning as much net investment income as possible at the end of the day.

A strategic tax plan should come into play when designing a solid investment strategy. Too often, however, investors forget that they are investing and see themselves only as taxpayers. 

They become fixated on reducing taxes, which can cause those investors to take their eyes off the prize and lose sight of the real goal — to earn as much as possible. So when you’re making investment decisions, be sure to compare your return potential after taxes.

In other words, if you see an opportunity to grab better-than-average returns by adding a few dividend stocks with high yields, it’s worth considering. (Investors Alley’s Dividend Hunter newsletter can show you which high-yield picks to choose.)

Invest For the Road Ahead

Couple holding hands while sitting on beach chairs and watching the sunset

Dividend investing can help you achieve long-term financial security. In terms of building wealth and minimizing taxes, the patient investor wins in the end. Buy solid companies, hold them as they build momentum, and collect dividend income along the way. This is how you pave the road to a financially secure retirement. 

Qualified dividends are tax-efficient and a source of reliable investment income. As long as the dividend is being paid by a U.S. or a qualified foreign corporation and you hold onto the dividend stock for the prescribed holding period, you’ll pay less in taxes and have more for retirement. 

For a financially secure retirement, become an investor who purchases shares of high-quality dividend stocks and play the long game. To learn about three dividend stocks we think you should buy and hold forever, subscribe to Investors Alley “Dividend Hunter” newsletter.

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