What Are Qualified Dividends?
Qualified dividends are dividends from security holdings that meet certain tax requirements and are then taxed at the capital gains rate, in contrast with nonqualified or ordinary dividends, which are taxed at the same rate as ordinary income. The tax rate for qualified dividends and capital gains is lower than the rate for nonqualified dividends and traditional income. Investors can increase their returns by meeting the tax requirements for qualified dividends.
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What are Qualified Dividends?
Dividends are classified as qualified or ordinary, and each is subject to a different rate that can affect the investor’s overall returns. The qualified dividends tax rate ranges from 0% to 15% to 20%, based on the person’s tax bracket. The ordinary dividends tax rate is the same as the person’s federal income tax rate, which ranges from 10% to 37% for the upcoming tax year.
The main difference between qualified and ordinary dividends is how they are taxed. The investor’s earnings will vary based on which category they fall. Most regular dividends from domestic companies are eligible for qualified dividends. The investor must also meet certain holding period requirements to get the lower tax rate.
The criteria described below must be met to qualify for the qualified dividends tax rate, according to the IRS:
- The dividends come from a U.S. company or a qualifying foreign company.
- The dividends are not listed under a category deemed ineligible for qualified dividends.
- The holding period requirements have been met.
Dividends from foreign companies can also qualify for the special tax rate as long as they meet one of these three requirements: the corporation is eligible for the benefits of a comprehensive income tax treaty with the U.S., The company is incorporated in a U.S. possession, or the stock is readily tradable on an established U.S. securities market, such as the S&P 500 or the Dow Jones Industrial Average.
Certain types of dividends are ineligible for the qualified tax rate, including those paid by master limited partnerships (MLPs), real estate investment trusts (REITs), those on employee stock options, and those from tax-exempt companies. Dividends from money market accounts, savings, and deposits in bank accounts do not qualify and should be taxed as interest income instead. One-time dividends also do not qualify for the lower tax rate. Qualifying dividends can also not come from holdings that have been hedged, including those with short, put, and call options.
What is the Holding Period for Qualified Dividends?
Qualified dividends must meet specific holding requirements to receive the lower tax rate. The holding period varies based on the type of security. The number of days included in the holding period is based on the day the investor sold the stock, not the day they acquired it. They can also not count days during which their “risk of loss was diminished,” according to the IRS.
For traditional stocks and securities, investors must hold onto the unhedged shares for at least 61 days out of the 121-day period that begins 60 days prior to the ex-dividend date, which occurs when the dividend has been paid out and after which any new buyers would then be eligible to receive future dividends.
For preferred stocks, investors must hold onto the stock for more than 90 days during the 181-day period that begins 90 days prior to the ex-dividend date.
Dividends from mutual funds accounts are subject to different holding period requirements, considering the fund manages the securities on behalf of the investor. For these dividends, the fund must hold onto the security unhedged for at least 61 days out of the 121-day period that begins 60 days prior to the stock’s ex-dividend date. Investors must then hold onto the applicable share of the fund for at least 61 days out of the 121-day period that begins 60 days before the fund’s ex-dividend date.
Are Qualified Dividends Taxable?
Yes, qualified dividends are taxable. They are subject to a lower tax rate than the person’s federal income tax rate and those for ordinary dividends.
They are listed on the 1099-DIV tax form, which is provided to investors when they receive distributions from an investment in the course of the calendar year. Qualifying dividends go in box 1b, while ordinary returns go in box 1a.
How are Qualified Dividends Taxed?
The tax rate for qualified dividends is based on the investor’s tax bracket. They are taxed at a rate of 0%, 15%, and 20%, respectively. For the 2022 tax year, the following income brackets apply:
- Investors making $0 to $41,675 per year when filing as single, or $0 to $83,350 when married and filing jointly, pay a tax rate of 0% for qualified dividends.
- Investors making $41,676 to $459,750 when single, or $83,351 to $517,200 when filing jointly, pay a rate of 15% for qualified dividends.
- Investors making $459,751 or more when single, or $517,201 or more when filing jointly, pay a rate of 20% for qualified dividends.
Individual investors with a modified adjusted gross income (AGI) over $200,000, or $250,000 for married investors, are subject to an additional 3.8% Net Investment Income Tax (NIIT). For example, if a person makes over $200,000 a year and would normally pay a 15% tax rate for qualified dividends, their rate would go up to 18.3%, which is still lower than the federal income tax rate.
Investors must divide their dividends into two categories when filing their taxes: qualified and ordinary. Dividends that qualify should receive the specialized tax rate, while ordinary dividends will be taxed as regular income.
For example, if an investor owns 1,000 shares of a company and holds onto 100 of them for at least 31 days and the other 900 for at least 61 days, any dividend income from the 100 shares sold after 31 days would count as ordinary dividends and be taxed as regular income. The dividend income from the 900 shares that were sold after 61 days would count as qualified dividends and be taxed at the specialized rate.
While ordinary dividends tend to be the most common in the U.S., qualified dividends come with certain tax advantages that increase returns.