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Ordinary Dividends vs. Qualified Dividends

Dividends paid by companies to investors come in two types – ordinary and qualified – and the difference has a major effect on the taxes that will be due. Ordinary dividends are taxed as ordinary income, meaning an investor must pay federal taxes on the income at the individual’s normal rate. Qualified Dividendson the other hand, are taxed at capital gains rates. Lower-income recipients of qualified dividends may not owe any federal tax at all. A Financial Advisor can help you find a range of effects that best suit your needs.

Dividends from holdings of shares of companies can be classified as qualified dividends and qualify for the lower capital gains rate if the investor has owned them for a minimum period of time. Dividends received from some sources, including: real estate investment trusts (REITs) and money market funds, are generally classified as regular dividends, regardless of how long they’ve been in a portfolio.

Ordinary Dividends vs. Qualified Dividends: The Background

Prior to 2003, all dividends were ordinary dividends and the recipients paid tax on them at their customary individual marginal rate. However, the tax cut bill that went into effect that year introduced another exception for qualified dividends as a way to encourage companies to pay dividends on their stock. Since then, the opportunity to get favorable tax treatment on dividends has made it a bigger focus for both companies and investors.

What are Qualified Dividends?

Ordinary Dividends vs. Qualified Dividends

Ordinary Dividends vs. Qualified Dividends

Regular dividends paid on shares of domestic companies are generally qualified as long as the investor has held the shares for a minimum period of time. The rule of the tax authorities says the stock must be held for more than 60 days during the 121 day period beginning 60 days before the ex-dividend date. For preferred stock, the shares must be owned for more than 90 days during the 181 days beginning 90 days before the ex-dividend date.

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The ex-dividend date is the earliest date after a dividend has been determined that a buyer of the dividend is not entitled to the declared dividend. The shares must also be hedged during the holding period. This means that the investor cannot have used any short sells, puts or calls on the stock during the holding period.

If the dividends meet the definition of qualified, the investor would owe no more than 20% tax on the income. This top rate only applies to high-income filers whose marginal tax rate is a maximum of 37%. Filers with a marginal rate of less than 37% but at least 15% would owe 15%. Files whose income would be taxed at 10% or 15% are not subject to federal income tax.

What are Ordinary Dividends?

Most dividends from a company or mutual fund are ordinary dividends and are taxed as ordinary income, at the investor’s usual marginal tax rate. There are some companies whose dividends are treated differently and their dividends are always or almost always classified as ordinary income.

These dividend payers include:

  • Money Market Funds

  • Banks, thrift and similar institutions that pay interest on deposits

  • Real Estate Investment Trusts

  • Master Limited Partnerships

  • Employee share ownership plans

  • foreign companies

Using Form 1099-DIV

It is not necessary for taxpayers to find out for themselves which dividends are ordinary and which are qualified. Dividend payers do this for them and report the information to both taxpayers and the IRS using the 1099-DIV form.

For planning purposes, it’s still a good idea for investors to have an idea ahead of time whether dividends will be treated as qualified or ordinary. For example, it is often a good idea to keep securities that generate regular dividends in a tax-advantaged account such as an IRA or 401(k).

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Bottom Line

Ordinary Dividends vs. Qualified Dividends

Ordinary Dividends vs. Qualified Dividends

The IRS rules regarding the classification of dividends as ordinary or qualified are complex and can be difficult for dividend investors to tell them, before they receive a 1099-Div form, how their income from dividends will be taxed. Ordinary dividends are taxed as ordinary income at an individual investor’s regular marginal tax rate. Qualifying dividends are taxed at the lower capital gains rate.

The length of time an investor owns a security helps determine whether its dividends will be considered ordinary or qualified. In general, if a stock has been owned for more than a few months, the dividends are likely to be qualified. The exceptions include securities from certain dividend payers, such as REITs and money market funds.

Tips for investing

  • A Financial Advisor can help you determine whether a dividend is classified as qualified or plain and provide advice on how to manage taxes that will be due on the income. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool match you with up to three financial advisors serving your area, and you can interview your advisors free of charge to decide which one is right for you. If you are ready to find an advisor who can help you achieve your financial goals, start now.

  • Income in America is taxed by the federal government, most state governments, and many local governments. The federal income tax system is progressive, so the tax rate rises as income rises. A Free Federal Income Tax Calculator can give you a quick estimate of what you owe Uncle Sam.

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