What Is a Nonqualified Dividend?
A nonqualified dividend is dividend income that doesn’t qualify for the specialized tax rate for qualified dividends. Regular dividends are separated into two categories: qualified and ordinary, or nonqualified dividends. Nonqualified dividends are treated as regular income by the IRS and are taxed at a higher rate than qualified dividends. Nonqualified dividend income can lower the investor’s returns, as they will have to pay more in taxes.
What are Nonqualified Dividends?
Qualified dividends must meet special requirements to receive a specialized tax rate, ranging from 0% to 20%, based on the person’s tax income bracket. Nonqualified dividends do not meet these requirements and are therefore subject to a higher tax rate. They have the same tax rate as the investor’s federal income tax rate, which is based on the person’s modified adjusted gross income (AGI), ranging from 10% to 37% for the 2022 tax year. This is also the same as the capital gains tax rate.
All regular dividends from domestic U.S. companies are eligible for the qualified tax rate. A nonqualified dividend refers to any type of dividend income that doesn’t qualify for the lower tax rate, including dividends from foreign companies that don’t meet at least one of the following three criteria: the company is eligible for the benefits of a comprehensive income tax treaty with the U.S., the corporation is incorporated in a U.S. possession, or the stock is readily tradable on an established U.S. securities market.
Nonqualified dividends also include special one-time dividends and dividends from nonqualifying investment categories, including those from master limited partnerships (MLPs), real estate investment trusts (REITs), tax-exempt companies, and those on employee stock options.
Regular dividends that don’t meet the minimum holding period for qualified dividends are also considered nonqualified. According to the IRS, those investing in traditional stocks must hold onto the unhedged securities for more than 60 days during a 121-day period, which starts 60 days before the ex-dividend date, or the day after the dividend payment has been processed and after which any new buyers would be eligible to collect future dividends, to receive the qualified tax rate.
Meanwhile, those investing in preferred stocks must hold onto the unhedged securities for more than 90 days during a 181-day period that starts 90 days prior to the ex-dividend date. Regarding mutual funds: The fund must hold onto the security unhedged for at least 61 days of the 121-day period that begins 60 days prior to the ex-dividend date, and the investor must hold onto their portion of the fund for the same period as well.
For all holding periods, the number of days includes the day the investor sold the stock but not the day they acquired it. They also can’t include days during which their “risk of loss was diminished,” according to the IRS.
How Are Nonqualified Dividends Taxed?
Nonqualified dividends are taxed as regular income and are subject to the same rate as the person’s federal income tax rate, ranging from 10% to 37%. Nonqualified dividend income is listed in box 1a of the 1099-DIV IRS form, while qualified dividends go in box 1b.
Investors can use their AGI to calculate their tax rate for nonqualified dividends for the 2022 tax year:
For individuals making u to $9,950 a year and married couples filing jointly making up to $19,900 a year, the nonqualified dividend income tax rate is just 10%.
For individuals making $9,951 to $40,525 a year and married couples filing jointly making $19,901 to $81,050 a year, the nonqualified dividend income tax rate is 12%.
For individuals making $40,526 to $86,375 a year and married couples filing jointly making $81,051 to $172,750 a year, the nonqualified dividend income tax rate is 22%.
For individuals making $86,376 to $164,925 a year and married couples filing jointly making $172,751 to $329,850 a year, the nonqualified dividend income tax rate is 24%.
For individuals making $164,926 to $209,425 a year and married couples filing jointly making $329,851 to $418,850 a year, the nonqualified dividend income tax rate is 32%.
For individuals making $209,426 to $523,600 a year and married couples filing jointly making $418,851 to $628,300 a year, the nonqualified dividend income tax rate is 35%.
For individuals making over $523,600 and married couples filing jointly making over $628,300, the nonqualified dividend income tax rate is 37%.
Investors will need to separate their dividend income into two categories when filing their taxes. For example, if an investor owns 1,000 shares of a company and sells 100 of them after owning them for less than 60 days during the 121-day period that starts 60 days before the ex-dividend date, the dividend income from the 100 shares they sold would count as nonqualified dividends, and the remaining 900 shares would be qualified dividends, assuming they held onto them for more than 60 days during the 121-day period that starts 60 days before the ex-dividend date.
The tax rate for nonqualified dividends is usually much higher than that of qualified dividends, which will dramatically affect the investor’s rate of return. Investors may benefit from prioritizing qualified dividends over nonqualified dividends for tax purposes.
There isn’t a lot that investors can do to change the qualification status of their dividends other than meet the holding period requirements. Nonqualified dividends tend to be more common than qualified dividends, but the latter can help investors maximize their earnings.