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Ordinary dividends vs. Qualified Dividends

Dividends paid by corporations to investors come in two forms – ordinary and qualified – and the difference has a big impact on the taxes that will be owed. Ordinary dividends are taxed as ordinary income, meaning that an investor must pay federal taxes on the income at the individual’s regular rate. On the other hand, qualified dividends are taxed at capital gains rates. Lower-income recipients of qualified dividends may owe no federal tax at all. A financial advisor can help you find the many securities that best meet your needs.

Dividends from ownership of shares in corporations may be classified as qualified dividends and eligible for the lower capital gains rate if the investor has owned them for a minimum period. Dividends received from certain sources, including real estate investment trusts (REITs) and money market funds, are generally classified as ordinary dividends regardless of how long they have been in a portfolio.

Ordinary dividends vs. Qualified Dividends: The Background

Before 2003, all dividends were ordinary dividends and recipients paid taxes on them at their ordinary individual marginal rate. However, the tax cut law enacted that year established a new exception for qualified dividends as a way to encourage companies to pay dividends on their shares. Since then, companies and investors have increasingly focused on dividends because of the opportunity to receive favorable tax treatment.

What are Qualified Dividends?

Ordinary dividends vs.  Qualified Dividends

Ordinary dividends vs. Qualified Dividends

Regular dividends paid on shares of domestic corporations are usually qualified as long as the shares are held by the investor for a minimum period. An Internal Revenue Service rule states that the shares must be owned for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. In the case of preference shares, the stock must be owned for more than 90 days during the 181 days beginning 90 days before the ex-dividend date.

The ex-dividend date is the earliest date after a dividend has been declared that the purchaser of the dividend will not be entitled to receive the declared dividend. The shares must also be de-vested during the holding period. This means that the investor cannot use any short sales, offers or calls related to the shares during the holding period.

If the dividends meet the definition of qualified, the investor would not have more than 20% of tax on the income. That maximum rate only applies to high income filers whose maximum marginal tax rate is 37%. 15% would be due for filers whose marginal rate is less than 37% but at least 15%. Filers whose income would be taxed at 10% or 15% would have no federal income tax.

What are Ordinary Dividends?

Most dividends from a corporation or mutual fund are ordinary dividends and are taxed like ordinary income, at the investor’s ordinary marginal tax rate. There are some businesses 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, thrifts and similar institutions that pay interest on deposits

  • Real estate investment trusts

  • Master limited partnerships

  • Stock ownership plans for employees

  • foreign corporations

How to Use Form 1099-DIV

Taxpayers do not need to work out for themselves whether a dividend is ordinary or qualified. Dividend payers do this on their behalf and report the information to taxpayers as well as the IRS using the 1099-DIV form.

For planning purposes, it is still a good idea for investors to consider in advance whether dividends will be treated as qualified or ordinary dividends. For example, it is often a good idea to hold securities that generate ordinary dividends in a tax-advantaged account such as an IRA or 401(k).

Base line

Ordinary dividends vs.  Qualified Dividends

Ordinary dividends vs. Qualified Dividends

The IRS rules regarding the classification of dividends as ordinary or qualified dividends are complex and it can be difficult for dividend investors to tell, before they receive a 1099-Div form, how their dividend income will be taxed. Ordinary dividends are taxed as ordinary income at an individual investor’s regular marginal tax rate. Qualified 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. Generally, if a stock has been owned for more than a few months, its dividends will likely qualify. The exceptions include certain dividend-paying securities, such REITs and money market funds.

Tips for Investing

  • A financial adviser can help you decide whether a dividend will be classified as a qualified or ordinary dividend and provide advice on how to manage the taxes due on the income. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors serving your area, and you can interview your advisor at no cost to decide which one is right for you. If you’re ready to find an advisor to help you achieve your financial goals, get started now.

  • Income tax in America is levied by the federal government, most state governments and many local governments. The federal income tax system is progressive, so the rate of taxation increases as income increases. A free federal income tax calculator can give you a quick estimate of how much you owe Uncle Sam.

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