It’s no secret that one of the most attractive types of securities for investors to own are those that pay dividends. Dividends are the distributions that a company or fund chooses to give back to its shareholders – generally from the profits or gains that it generates. The more shares an investor owns, the more passive income they’re entitled to collect.
With more than 75 percent of stocks and ETFs (exchange-traded funds) paying a dividend, it’s a pretty safe bet that many Americans will report these earnings in some form on their tax return. However, the big question will be: Should they be claimed as qualified or ordinary dividends?
In this post, we’ll explore the difference between the two and give you an easy way to tell the difference. We’ll also explain why making qualified dividends a part of your portfolio is so lucrative to investors.
What Are Qualified Dividends?
Qualified dividends are simply dividends that “qualify” to receive preferential treatment from the IRS. In other words, you’ll pay lower taxes on this income.
To be considered qualified, these distributions must:
- Come from shares that were held for at least 61 days within a 121-day period that begins 60 days before the ex-dividend date.
- Be issued by domestic corporations and certain qualifying foreign corporations.
If the dividends are considered qualified, then they’ll be subject to more favorable capital gains tax rates. These brackets are currently 0%, 15%, and 20%. By contrast, the tax brackets for ordinary income go all the way up to 37%, and income thresholds are much lower.
Example of Qualified Dividends
Suppose you bought shares of popular dividend stock Verizon Communications (symbol: VZ) over a year ago. Since Verizon is a U.S. company and you’ve clearly held the stock longer than 61 days, then the dividends you’re receiving would be classified as qualified dividends.
What Are Ordinary Dividends?
Ordinary dividends (also called non-qualified dividends) are those distributions that do not meet the IRS requirements to be considered “qualified”. This will usually be because the shareholder didn’t own the shares for long enough, or that the dividends came from a non-domestic company.
Ordinary dividends are paid by various types of assets, including certain stocks, mutual funds, and ETFs. The dividends from REITs (real estate investment trusts), another popular high-yield security, also are considered non-qualifying because of the special tax treatment for these types of organizations.
Unlike qualified dividends, ordinary dividends do not receive special tax treatment. They will be taxed at the same rates as the money you earn from your job.
Example of Ordinary Dividends
Let’s again use Verizon in our example. We already established Verizon as a domestic company, so no issue there.
Let’s assume you bought your shares right before the ex-dividend date so that you’ll receive a dividend payment. However, you then sold the shares four weeks later to pursue another investment. Since you did not meet the IRS 61-day minimum holding requirement, the dividend income you’ll receive will be taxed as ordinary.
How Do I Know When Dividends Are Qualified or Ordinary?
The easy way to tell the difference between qualified and ordinary dividends is to let your brokerage tell you. Each year, all U.S. financial institutions are required to send out IRS tax form 1099-DIV to those customers who receive dividend income. This form will clearly state how much of their distributions counts as qualified versus ordinary (boxes 1a and 1b).
What Are the Benefits of Qualified Dividends?
The main advantage of income from qualified dividends is better tax treatment. Depending on how much of your money comes from these distributions, you may pay several thousand dollars less each year to the government than your peers.
For example, consider two people with AGIs (adjusted gross income) of $100,000. One person gets all their income from a regular job while the other makes their money solely from qualified dividends.
Using 2023 tax rates and assuming each file a joint return with their spouse:
- The person with the job (i.e. ordinary income) would be in the 22% marginal tax bracket and pay approximately $12,615 in federal taxes.
- The person with qualified dividend income wouldn’t even pay any taxes on the first $89,250 of distributions they received. The remaining $10,750 would be taxed at 15% for a total of $1,613 in federal taxes.
As you can see, that’s quite a major difference in tax liability. This is why the wealthy often pay a lower effective tax rate than lower and middle-class citizens. Since the upper class is more likely to receive distributions from investment returns, there’s a good chance that this income will be considered qualified and taxed lower than money earned from a traditional job.
This can be a powerful strategy for anyone looking to retire with the lowest tax bill possible. In conjunction with other tax-efficient moves (such as utilizing a Roth IRA), investing in qualified dividends can be another way to keep your federal taxes to a minimum.
How to Acquire More Qualified Dividends
If owning more dividend-paying securities sounds like something that you’d like as part of your overall investment strategy, then here are a few tips for acquiring them.
Do Your Homework
First things first, look for stocks or funds whose distributions will count as qualified according to the IRS. These will typically be large blue-chip companies that are common household names such as IBM or Johnson and Johnson.
During your research, you’ll probably discover that REITs and some foreign stocks may pay higher dividends. While it’s okay to own these types of securities as well, again – be mindful that they won’t qualify for preferential tax treatment.
Invest for the Long Term
With your investment targets selected, the next thing to do is to buy and hold them – preferably longer than the IRS 61-day requirement. In general, adopting a long-term mindset for your portfolio is a better strategy anyway because most securities tend to do better with time.
Consider the Type of Account
Tax-deferred retirement accounts like 401(k)s and traditional IRAs are great for building your nest egg. However, the withdrawals from these accounts are typically treated as ordinary income – regardless of whether they are contributions, capital gains, or dividends. To qualify for better tax treatment, your securities would need to be held in a regular taxable brokerage account and not a retirement account.
This doesn’t automatically mean that you should stop contributing to your 401(k) or IRA. Again, you’ll have to consider the whole picture. In instances where you already invest outside of your retirement accounts, buying assets that produce qualified dividends can be more tax efficient over other options such as putting your money into a high-interest account.
Are Qualified Dividends Right for You?
Dividends are great for investing and smart passive income. However, they can be even more lucrative if they qualify for preferential tax treatment. Do this by paying attention to which securities you buy, how long you own them, and which accounts you hold them in. Be sure to weigh the tax benefits with your overall investment strategy.
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