Ordinary Dividends vs. Qualified Dividends: Differences and Tax Treatment
Companies use dividends as a way to share their profits with their shareholders. However, not all dividends are taxed the same way by the IRS. Depending on the type of dividend, you may pay more or less taxes on your dividend income.
In this article, we will explain the differences between ordinary dividends and qualified dividends and how they affect your tax bill.
Key Takeaways
Ordinary dividends are the default type of dividends that are paid by most corporations to their shareholders. They are taxed as ordinary income at your marginal tax rate.
Qualified dividends are dividends that meet certain criteria set by the IRS, such as being paid by a U.S. or qualifying foreign corporation and being held for a minimum period of time. They are taxed at the lower capital gains rate, which can range from 0% to 20%, depending on your income level.
The tax treatment of dividends can have a significant impact on your after-tax return, so it is important to understand the difference between ordinary and qualified dividends and how to optimize your portfolio accordingly.
What are Ordinary Dividends?
Shareholders of record receive a periodic payment from the corporation’s earnings, which are called ordinary or non-qualified dividends. These dividends are the default type unless they meet certain criteria that make them qualified dividends.
The tax rate for ordinary dividends is the same as the tax rate for regular income, while the tax rate for qualified dividends is lower and matches the tax rate for capital gains.
The IRS has certain criteria that make some dividends qualified; otherwise, they are ordinary by default. These requirements include:
The dividend must be paid by a U.S. corporation or a qualifying foreign entity. A qualifying foreign entity is either a corporation that is incorporated in U.S. possession or a corporation that is eligible for benefits under a comprehensive income tax treaty with the U.S.
The dividend must be actually a dividend in the eyes of the IRS. Some payments that are called dividends are not considered as such for tax purposes, such as:
Premiums an insurance company kicks back.
Annual distributions credit unions make to members.
“Dividends” from co-ops or tax-exempt organizations.
Dividends that are actually capital gains distributions from mutual funds or REITs.
The shareholder must hold the underlying security for long enough. The holding period requirement is that the shareholder must own the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. The ex-dividend date is the date by which you must own the stock to receive the dividend. For preferred stock, the holding period is 90 days within a 181-day period.
If any of these requirements are not met, the dividend is considered ordinary and taxed as ordinary income.
What are Qualified Dividends?
Qualified dividends are dividends that meet all of the criteria mentioned above for ordinary dividends, plus some additional ones. Qualified dividends are taxed at the same rate as long-term capital gains, which can be much lower than ordinary income tax rates.
The additional criteria for qualified dividends are:
You must meet the holding period requirement for the dividend-paying stock. You must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.
If the dividend is paid on preferred stock, you must have held the stock for more than 90 days during the 181-day period that begins 90 days before the ex-dividend date.
The dividend must be paid by a U.S. corporation or a qualifying foreign entity that is not classified as a passive foreign investment company (PFIC). A PFIC is a foreign corporation that meets either of these tests:
At least 75% of its gross income is passive income (such as interest, dividends, rents, royalties, etc.)
At least 50% of its assets produce passive income or are held for producing passive income.
The dividend must not be on the IRS list of dividends that are not qualified. These include:
Dividends paid by real estate investment trusts (REITs), regulated investment companies (RICs), or master limited partnerships (MLPs).
Dividends paid by entities that are tax-exempt or have not paid any income taxes in the U.S. or their home country.
Dividends paid by entities that have received certain types of federal subsidies or financing.
Dividends related to certain transactions involving options, short sales, or hedging.
If all of these criteria are met, the dividend is considered qualified and taxed at the lower capital gains rate.
Ordinary Dividends vs. Qualified Dividends Tax Treatment
The tax treatment of dividends in the U.S. depends on whether the Internal Revenue Code (IRC) classifies them as qualified dividends or ordinary dividends (also referred to as nonqualified dividends.) Qualified dividends are taxed at the same rates as the capital gains tax rate, which are lower than ordinary income tax rates.
Ordinary income tax rates apply to ordinary dividends, which are the most common type of dividends paid by most stocks. Ordinary dividends are taxed at the same rates as your regular income, such as salary or wages.
The tax rates for qualified dividends are the same as the long-term capital gains tax rates. These rates are lower than the ordinary income tax rates and depend on your taxable income and filing status. To check the current tax rates, check out the Nerdwallet dividend tax rate article.
Dividend Tax Rate vs. Capital Gains Tax Rate
Qualified dividends have the same tax treatment as long-term capital gains. However, it is important to understand the difference between dividends and capital gains in general.
Dividends are usually paid in cash, but sometimes they can be paid in stock or other forms of property. Dividends represent a return on investment for shareholders and are usually paid quarterly or annually.
Capital gains occur when there is a positive difference between the sale and purchase price of an asset. Capital gains can be realized by selling stocks, bonds, real estate, or other assets. Capital gains represent a change in the value of an investment over time and are realized only when the asset is sold.
Taxes apply to the income that investors make from dividends or capital gains. However, the way that dividends and capital gains are taxed depends on various factors, such as:
The type of dividend (ordinary or qualified)
The type of capital gain (short-term or long-term)
The holding period of the asset (how long you owned it before selling it)
The taxable income and filing status of the investor
The applicable tax rate and brackets
Short-term capital gains are gains from selling assets that you owned for one year or less. Short-term capital gains are taxed as ordinary income at your marginal tax rate.
Long-term capital gains are gains from selling assets that you owned for more than one year. Long-term capital gains are taxed at the lower capital gains rate, which can range from 0% to 20%, depending on your income level.
Ordinary dividends are taxed as ordinary income at your marginal tax rate.
Qualified dividends are taxed at the lower capital gains rate, which can range from 0% to 20%, depending on your income level.
As you can see, the tax treatment of dividends and capital gains can have a significant impact on your after-tax return. Therefore, it is important to understand the difference between ordinary and qualified dividends and how to optimize your portfolio accordingly.
Ordinary Dividends vs. Qualified Dividends | Bottom Line
Dividends are a great way to earn passive income from your investments. However, not all dividends are created equal when it comes to taxes. Depending on the type of dividend you receive, you may pay more or less taxes on your dividend income.
Ordinary dividends are the default type of dividends that are paid by most corporations to their shareholders. They are taxed as ordinary income at your marginal tax rate.
Qualified dividends are dividends that meet certain criteria set by the IRS, such as being paid by a U.S. or qualifying foreign corporation and being held for a minimum period of time. They are taxed at the lower capital gains rate, which can range from 0% to 20%, depending on your income level.
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FAQ
How do I know if my dividends are qualified or ordinary?
You can check the Form 1099-DIV that you receive from your broker or financial institution at the end of the year. Box 1a shows your total ordinary dividends, while box 1b shows your qualified dividends. You can also refer to the IRS Publication 550 for more information on how to determine if your dividends are qualified or not.
How do you avoid tax on qualified dividends?
You can avoid tax on qualified dividends if your taxable income falls below a certain threshold, depending on your filing status. You can view the thresholds in Nerdwallets’ article.
If your taxable income is below these amounts, you will pay 0% tax on your qualified dividends. However, you may still have to pay state and local taxes on your dividend income.
Are dividends taxed in a Roth IRA?
No, dividends are not taxed in a Roth IRA as long as you follow the rules for withdrawals. You can invest in dividend-paying stocks or funds in your Roth IRA and enjoy the benefits of tax-free compounding and tax-free income.
However, you have to meet certain requirements to withdraw money from your Roth IRA without paying taxes or penalties. These include:
Being at least 59 and a half years old
Having the account for at least five years
Having a qualified reason for withdrawal, such as buying a first home, paying for education, or facing a disability
If you withdraw money from your Roth IRA before meeting these requirements, you may have to pay taxes and penalties on the earnings portion of your withdrawal.
What are examples of qualified dividends?
Some examples of qualified dividends are:
Dividends paid by U.S. corporations or qualifying foreign corporations that are traded on a U.S. stock exchange or have a comprehensive income tax treaty with the U.S.
Dividends paid by mutual funds or exchange-traded funds (ETFs) that invest in U.S. or qualifying foreign corporations
Dividends paid by American depositary receipts (ADRs) that represent shares of qualifying foreign corporations
However, not all dividends paid by these entities are qualified. You also have to meet the holding period requirement and other criteria set by the IRS.
What are the advantages of qualified dividends?
The main advantage of qualified dividends is that they are taxed at the lower capital gains tax rate, which can save you a lot of money on taxes compared to ordinary dividends.
Do qualified dividends put you in a higher tax bracket?
Yes, qualified dividends are added to your income for the purpose of determining your tax bracket. However, qualified dividends are not taxed at the same rate as your ordinary income. Rather, they are taxed at the lower capital gains tax rate.
Are qualified dividends added to income?
Yes, qualified dividends are added to income for certain purposes, such as calculating your adjusted gross income (AGI), your modified adjusted gross income (MAGI), and your net investment income (NII). However, qualified dividends are still taxed at the capital gains tax rate, not as ordinary income.
How much of qualified dividends are tax-free?
Qualified dividends are only tax-free if your taxable income falls within the 0% dividend tax rate bracket. If you make more than the 0% bracket for a particular year, none of your qualified dividends will be tax-free.
Are REIT dividends qualified?
No, REIT dividends are not qualified. REITs distribute most of their earnings to their shareholders as dividends. However, REIT dividends are not eligible for the lower capital gains tax rate because they do not meet the criteria to be classified as qualified dividends. REIT dividends are taxed as ordinary income at your marginal tax rate. This is why many investors prefer to buy REITs in a ROTH IRA.
However, there is an exception for REIT dividends that are attributable to capital gains from the sale of property by the REIT. These dividends are called capital gain distributions, and they are taxed at the capital gains tax rate. You can find out how much of your REIT dividends are capital gain distributions by looking at the Form 1099-DIV that you receive from your broker or financial institution.
Are dividends taxed when declared or paid?
Dividends are taxed when paid, not when declared. A dividend is declared when the board of directors of a corporation announces that it will pay a dividend to its shareholders on a certain date. A dividend is paid when the corporation actually distributes the dividend to its shareholders.
