What is a Qualified Dividend?

A qualified dividend is like getting a senior citizen discount…

When you go to the movies, you wait in line and purchase seats in the same theater as everyone else. But the business may offer a discount to people over a certain age. If you meet the requirements, you can qualify for the discounted price. Similarly, if your dividend meets the requirements, it may be taxed at the lower rate for capital gains — as opposed to being taxed as income.

When a company distributes some of its earnings to the owners of the company, it is known as a dividend. Since stock is an equity interest in a company, owners of common shares receive a part of those payments whenever the company issues a dividend. All cash dividends are classified as either ordinary or qualified. Unless the company is not eligible to issue qualified dividends, the distinction comes from whether or not the shareowner meets certain holding requirements.

The difference between ordinary and qualified dividends lives in the taxes that are owed on the dividend payment. If the payment is classified as an ordinary dividend, then it is added to the recipient's ordinary income. That person would pay taxes on the income at the same rate as their other income.

But, if the payment is categorized as a qualified dividend, then the income counts as capital gains. Taxes on capital gains are typically lower than on ordinary income. So, the qualification for the lower tax rate can be meaningful.

As a side note, not all dividends are cash dividends. If you are a business owner who received special privileges from your business, or non-cash compensation, that could be considered a dividend. Or, if you receive additional stock rather than cash, that is also a dividend. In those cases, the tax implications might be a little more complicated.

After the end of a tax year, companies that paid a dividend during the year will send the tax form 1099-DIV. This is one of the forms that you will use to prepare your tax return that is due in April. The issuing company is responsible for disclosing this information to you and the Internal Revenue Service (IRS).

On that form, box 1 will inform you of the amount of ordinary and qualified dividends they sent you. The amount in box 1a tells you how much they paid you in ordinary dividends. Box 1b will show how much you received in qualified dividends. You will use this information to file a schedule b, which is attached to your form 1040 tax return.

A dividend payment is not technically a capital gain. It is a distribution of earnings to owners. As such, dividends would normally be taxed as ordinary income. However, if the distribution meets certain requirements, it can qualify as though it were a long-term capital gain.

Capital gains occur when you sell an asset for more than its book value (the purchase price minus depreciation). This includes financial assets, like stocks. If you sell a stock for more than you purchased it for, that is a capital gain. For tax purposes, the Internal Revenue Service (IRS) treats short-term capital gains (gains on assets owned less than a year) as ordinary income. Long-term capital gains have a separate, lower tax rate.

The IRS says that ordinary dividends are the most common type of distribution. But most companies that are listed on a U.S. stock exchange can issue qualified dividends. Three criteria must be met to qualify.

1. The issuing company must be a U.S. corporation or a qualified foreign corporation. To be qualified, the foreign company must be incorporated in the United States, traded on a U.S. stock exchange, or operating under a comprehensive income tax treaty with the United States.
2. The dividend cannot be listed as ineligible by the IRS, such as the distribution of capital gains, interest on deposits with certain financial institutions, payments from mutual funds or real estate investment trusts, and dividends from tax-exempt organizations.
3. The recipient of the dividend must meet a holding-period requirement.

For most situations, the difference between ordinary and qualified dividends rests on the required holding period. For common stock, you must own the common shares for at least 60 of the 121 days extending 60 days before and 60 days after the ex-dividend date (the last trading day that entitles the new owner to a pending dividend).

So long as you purchase the stock before the ex-date, you will receive the dividend. But, unless you hold the stock for two months, it will count as an ordinary dividend. If you hold the stock for longer than those two months, you will get the tax advantage of a qualified dividend.

There is typically a longer holding period for annual preferred stock dividends. In that case, the holding period is 90 of the 181-day period that begins 90 days before the preferred stock ex-dividend date.

Some investors like to buy shares of companies that pay dividends. Those regular payments act like income, which tends to be a more stable addition to their earnings. These investors might hold dividend stocks for a long time, collecting several dividend payments each year. This buy-and-hold strategy is often rewarded at tax time. The earnings count as qualified dividends, which are taxed at the lower tax rate.

Other investors like to purchase stocks that they think will grow. Those investors might prefer that a company reinvest its earnings rather than pay dividends. In theory, the growth turns into more revenues and a higher stock price. Rather than receiving dividends, they get to sell that stock for more than they paid. Those capital gains are either taxed as ordinary income or as long-term capital gains, depending on how long you held the stock.

The difference in tax rates is meaningful. If you are in one of the bottom two income tax brackets, qualified dividends are tax-free. If you are in the top tax bracket, qualified dividends are taxed the maximum capital gains rate of 20%, while the rest of your income in that bracket is hit with a 37% tax rate. Everyone else pays 15% on their qualified dividends.

Let’s look at a few examples of how the tax liability changes on a dividend that goes from ordinary to qualified.

Example 1: Tom is a single taxpayer who earned $50,000 in taxable income last year. If a $1,000 dividend is characterized as ordinary, he will owe $220 of that dividend in taxes. But, if it is a qualified dividend, he only owes $150. Thus, a tax savings of $70.

Example 2: Tom is a single taxpayer with a dependent who earned $50,000 in taxable income last year. If a $1,000 dividend is characterized as ordinary, he will owe $220 of that dividend in taxes. But, if it is a qualified dividend, he owes nothing. Thus, a tax savings of $220.

Example 3: Bill and Sarah are married taxpayers who file jointly. Their combined gross income was $650,000 last year. They also received $100,000 in dividends. If those dividends are characterized as ordinary, they will owe $37,000 in taxes on those payments. But, if they are qualified dividends, they owe $20,000. Thus, a tax savings of $17,000.

Before making decisions with legal, tax, or accounting ramifications, you should consult the appropriate professional.