Many investors view dividends as the same, to their dismay. The government sees two types of dividends: Qualified Dividends and Ordinary Dividends. You do not know which one can negatively affect your portfolio and your wallet tax time.
I have been following the markets for over 25 years, and I sometimes get confused about whether an investment pays a qualified dividend. However, every investor should be able to distinguish between ordinary and qualified dividends. Anyone looking to maximize long-term returns is going to find it easy to learn some basic rules.
From the 100,000 foot perspective of the two types of dividends and their IRS classification matters, here’s a view.
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- 1 Key Ordinary vs. Qualified Dividends Tax Differences
- 2 What It Means For Investors
- 3 What is a Qualified Dividend?
- 4 Many Dividends That Do Not Qualify
- 5 The Holding Period
- 6 How Qualified Dividends Came To Be
- 7 Ordinary Dividends (Unqualified/Nonqualified)
- 8 Ordinary vs. Qualified Dividends: Final Thoughts
Key Ordinary vs. Qualified Dividends Tax Differences
Intelligent investors are concerned about how a stock’s dividend is classified. This has to do with the tax treatment of that stock.
The main distinction is that ordinary dividends are subject to ordinary income tax rates. No matter your income tax bracket, this is the rate you pay for ordinary dividends.
Sometimes, ordinary dividends are often referred to as unqualified dividends or nonqualified.
Qualified dividends are subject to long-term capital gains tax, which are significantly lower than ordinary income tax rates. If you are in a standard income tax bracket:
- A 10% to 15% tax bracket pays $0
- A 15% or less than 37%, are subject to 15% tax.
- A 37% tax bracket is subject to a 20% tax.
Remember that nonqualified dividends are taxed just like ordinary income and can make a significant difference in the amount you pay to the government.
Now that you have a good understanding of the basic breakdown of ordinary and qualified dividends, let’s look at how to use this knowledge to improve your portfolio’s tax efficiency.
What It Means For Investors
Most regular dividends from U.S. corporations are considered qualified. However, the difference between qualification and the alternative can be significant when it comes time to calculate taxes. The most crucial action an investor can take is holding stocks for the minimum holding period as stipulated by the type of stock detailed above.
The difference between qualified and nonqualified dividends can be seen when taxes are calculated in the tax brackets for foreign companies, such as REITs, MLPs, and other types of investment vehicles indicated above. On the other hand, the other thing you can do to have a bearing on whether or not dividends are qualified.
What is a Qualified Dividend?
A qualified dividend is a dividend that is classified under capital gains tax rates which are lower than the income tax rates on ordinary dividends or unqualified dividends. The tax rates for ordinary dividends are the same as standard federal income taxes. Qualified dividends are taxed as capital gains at rates of 0%, 15%, or 20%, depending on the individual’s tax bracket.
The difference between ordinary dividends and qualified dividends can be huge when it comes time to pay taxes. For example, a qualified dividend would be 10% to 37% for the tax year 2020. For the tax year 2019, the rate for qualified dividends is 10% or 12%.
Certain entities can only pay qualified dividends. These constraints will help you quickly determine what kind of payout StockX can pay and what account you may want to use to hold it if you decide to purchase it.
To qualify for dividends.
- They must be paid either by a U.S. corporation or a qualified foreign company with the stock traded on U.S. exchanges.
- They cannot satisfy the IRS’s definition of “dividends not qualified dividends,” which includes capital gains distributions, dividends paid by tax-exempt corporations, and payments in place thereof.
- Investors must have owned the stock for at least 60 days during the 121-day time frame, which begins 60 days before the ex-dividend date.
These IRS rules, while oddly formulated, have real-world consequences. Equal investments paying qualified dividends are better kept in taxable accounts than securities paying nonqualified dividends.
Many Dividends That Do Not Qualify
There are many dividends from investments that do not qualify. These include BDCs, REITs, MLP, and other partnerships. Dividends also paid from money market accounts do not qualify.
Money market accounts, such as deposits in savings banks, credit unions, or other financial institutions, should not qualify. Lastly, qualified dividends, a bit confusing, dividends that come from shares used for hedging, short sales, puts, and call options.
The Holding Period
IRS requires investors to own stock shares for a minimum period of time to be “qualified” and receive the lower tax rate. Investors must hold common stock shares for more than 60 days during the 121-day period, which starts 60 days before the ex-dividend date. Preferred stock has a 90 day followed by 181 days. Mutual fund investors must hold the investment 61 of 121 days, of which 60 must be before the ex-dividend date. I highly recommend seeking professional tax help if you don’t understand the holding. However, the general rule is that long-term shareholders of dividend stock shouldn’t worry about a holding period after the 121 day time window.
How Qualified Dividends Came To Be
Qualified dividends began with the 2003 tax cuts signed into law by George W. Bush. The lower qualified rate was designed to fix one of the significant unintended consequences of the U.S. tax code. By taxing dividends at a higher rate, the IRS was incentivizing companies not to pay them.
Instead, the tax code incentivized companies to do stock buybacks or hoard the cash. It’s debatable whether the lower rate had the desired effect; in the 17 years that have passed, companies (particularly in the tech sector) continue to hoard a lot of cash. Even tech darlings like Apple and Nvidia regularly pay dividends.
Ordinary Dividends (Unqualified/Nonqualified)
The IRS states that ordinary dividends are the most common type of distribution from mutual funds and corporations. These are income that is normal to taxpayers and not capital gains. The IRS advises taxpayers to assume any dividend from preferred or common stocks is an ordinary dividend unless the paying company/mutual funds state otherwise.
The best way to think of this is qualified means tax-advantaged, while ordinary means ordinary income. Common nonqualified or ordinary investments are REITs and MLPs.
This information can help you select the account you want to use to buy a particular income investment.
For tax-sensitive clients, it is best to invest in investments that pay ordinary dividends (REITs and taxable bonds) in an IRA or another tax-deferred account. You can also do this with 401(k).
Ordinary vs. Qualified Dividends: Final Thoughts
Dividing income can be a great way to create long-term wealth. Thoughtful tax planning is key to optimizing your results. You can avoid nearly all taxes by taking advantage of tax-deferred accounts such as an IRA or tax-free accounts such as a Roth IRA.
There are a lot of investments that pay ordinary dividends. I can only imagine seeing investors’ faces when paying taxes on REITs that yield 10% because they were qualified. REITs, which are pass-through entities, can have higher pretax returns than corporations. They are exempt from corporate-level taxes, and at least 90% of their income is passed on to shareholders. However, many are taxed as ordinary income.
It is crucial to consider both the tax implications and risk when investing. If a dividend-paying stock, the deciding factor should not be whether it is ordinary or qualified dividends. It should not be which one has a higher yield.
A high dividend is not always a good investment. Sometimes shares drop rapidly, or the dividend of a company is reduced significantly. This is a different topic.
I strongly recommend you seek a qualified investment/tax professional before investing in anything you are unsure about regarding the taxes. When you are investing in a taxable account, it is vital.