What Are Qualified Dividends?
Ordinary dividends are payments a public company makes to owners of its common stock shares. A qualified dividend is an ordinary dividend reported to the IRS as a capital gain rather than income. Individuals earning over $44,625 or married couples filing jointly who earn $89,250 pay at least a 15% tax on capital gains for the 2023 tax year.
Key Takeaways
- A qualified dividend is an ordinary dividend that meets the criteria to be taxed at capital gains tax rates, which are lower than income tax rates for some taxpayers.
- Qualified dividends must meet special requirements issued by the IRS.
- The maximum tax rate for qualified dividends is 20%, with a few exceptions for real estate, art, or small business stock. Ordinary dividends are taxed at income tax rates, which as of the 2023 tax year, maxes out at 37%.
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Understanding Qualified Dividends
A dividend is considered qualified if the shareholder has held a stock for more than 60 days in the 121-day period that began 60 days before the ex-dividend date. The ex-dividend date is one market day before the dividend's record date. The record date is when a shareholder must be on the company's books to receive the dividend.
For example, XYZ stock declares a dividend payment on Nov. 20, sets a record date for a month later, with an ex-dividend date of Dec. 19. Those who bought XYZ stock before Dec. 19 and held it for at least 61 days in the 121-day period that began 60 days before the ex-dividend date pay the capital gains tax rate on the dividend. Those who bought XYZ stock before Dec. 19 and received a dividend, but did not hold it for the required 61 days, would claim the dividend as ordinary income on their tax return for that year.
Individuals receive the next dividend if they purchase stock before the ex-dividend date.
Capital Gains Tax Rates
Capital gains are taxed at 0%, 15%, or 20%, depending on the taxpayer's income. Capital gains from selling collectibles or qualified small business stock may be up to 28%. Unrecaptured gains from selling section 1250 real property are taxed up to 25%. Most investors pay zero or 15%, with only the highest earners paying the 20% rate.
IRS Form 1099-DIV, Box 1a, Ordinary Dividends shows all taxpayer dividends. Qualified dividends are listed in Box 1b on form 1099-DIV and are the portion of ordinary dividends from Box 1a that meet the criteria to be treated as qualified dividends. Qualified dividends must have been paid by a U.S.company or a qualifying foreign company, and the required dividend holding period has been met.
Qualified Dividends vs. Ordinary Dividends
Qualified and ordinary dividends have different tax implications that impact a return. The tax rate is 0% on qualified dividends if taxable income is less than $44,625 for singles and $89,250 for joint-married filers in the tax year 2023.
Single filers who make more than $44,625 or $89,250 jointly have a 15% tax rate on qualified dividends. For those with income that exceeds $492,300 for a single person or $553,850 for a married couple, the capital gains tax rate is 20%.
There is an additional 3.8% Net Investment Income Tax (NIIT) on investment gains or income. The IRS uses the lowest figure of net investment income or the excess of the modified adjusted gross income (MAGI) that exceeds $200,000 for single filers, $250,000 for married filing jointly, and $125,000 for married filing separately to determine this tax.
What It Means for Investors
Most regular dividends from U.S. corporations are considered qualified, however, there are considerations for foreign companies, REITs, MLPs, or tax-exempt companies. A foreign corporation qualifies for the special tax treatmentif the company is incorporated in the U.S, the corporation is eligible for the benefits of a comprehensive income tax treaty with the United States,or the stock is readily tradable on an established securities market in the United States. A foreign corporation is not qualified if considered a passive foreign investment company.
Some dividends are automatically exempt from consideration as qualified dividends. These include dividends paid by real estate investment trusts (REITs), master limited partnerships (MLPs), employee stock options, and those on tax-exempt companies. Dividends paid from money market accounts, such as deposits in savings banks, credit unions, or other financial institutions, do not qualify and should be reported as interest income.
Special one-time dividends are also unqualified and qualified dividends must come from shares not associated with hedging, such as those used for short sales, puts, and call options.These investments and distributions are subject to the ordinary income tax rate.
What Are the Holding Periods for Other Investments?
Preferred stocks have a different holding period than common stocks and investors must hold preferred stocks for more than 90 days during a 181-day period that starts 90 days before the ex-dividend date.The holding period requirements are somewhat different for mutual funds. The mutual fund must have held the security unhedged for at least 60 days of the 121-day period, which began 60 days before the security's ex-dividend date. To receive capital gains tax treatment in a mutual fund, investors must have held the applicable share of the mutual fund for the same period.
Why Are Qualified Dividends Taxed More Favorably Than Ordinary Dividends?
The favorable tax treatment for qualified dividends is intended as an incentive to regularly use a share of their profits to reward their shareholders. It also gives investors a reason to hold onto their stocks long enough to earn dividends.
What Are the Requirements for a Dividend to Be Considered Qualified?
Stock shares that pay dividends must be held for at least 61 days within a 121-day period that begins 60 days before the ex-dividend date.
How Do Investors Know If the Dividends I've Received Are Qualified or Not?
The online trading platform or broker that an investor employs will break down the qualified and ordinary dividends paid in separate boxes on the IRS Form 1099-DIV. Ordinary dividends are reported in box 1a, and qualified dividends in box 1b.
The Bottom Line
For most individual investors, qualified dividends offer the chance of a tax break. The dividends of most American companies are qualified dividends. The investor's only concern should be to qualify for the lower capital gains tax rate by purchasing shares before the ex-dividend date and holding them for more than 60 days.
Correction—Nov. 28, 2023: This article has been corrected to state that a shareholder must buy a stock before the ex-dividend date and hold it for more than 60 days during a certain period in order for the dividend to be qualified.
