Qualified dividends fall under capital gains tax rates, which are lower than income tax rates for ordinary or unqualified dividends. Ordinary dividends, typically those paid from preferred or most common stocks, have the same tax rates as standard federal income tax rates. They range from 10% to 37% in tax years 2021 through 2022. Qualified dividends are subject to capital gains tax at 20% or 15%, depending on your tax bracket. This discrepancy can make it difficult to pay taxes because of the large difference in rates between qualified and ordinary dividends.
Understanding Qualified Dividends
Regular dividends can be classified as either ordinary or qualified. Each classification has different tax implications and impacts an investor's net returns. Qualified dividends are subject to a 10% or 12% tax rate for investors whose ordinary income is taxed at 10% and 12%, respectively. Qualified dividends are subject to a 15% tax rate for those who pay higher than 12% income taxes.
Qualified dividends are subject to a 20% tax rate for those who fall within the 35% and 37% tax brackets and individuals with an ordinary income of more than $445,000. These rates for long-term capital gains will be in effect through 2021. Notable is also the 3.8% NIIT, which applies to individuals with modified adjusted gross income above $200,000, or $250,000 for married taxpayers filing jointly.
Requirements for Qualified Dividends
Qualifying Foreign Companies
A foreign company can qualify for favorable tax treatment if the company satisfies the following conditions: A comprehensive income tax treaty with the United States must be in place for the company to be eligible for its advantages, and the corporation must be formed in a territory that is a part of the United States. Alternately, the stock has to be easily tradable on a securities market in the United States. If a foreign company is considered a "passive foreign investment firm," the foreign company will not be eligible.
Dividends That Do Not Qualify
Certain dividends can be automatically considered qualified dividends. These include dividends paid from MLPs, REITs, employee stock options, and tax-exempt companies. Dividends from money market accounts such as savings banks or other financial institutions are not eligible and should be reported under interest income.
Unqualified is also special one-time dividends. Qualified dividends cannot be earned from shares used to shorten sales, put options, or call options. All distributions and investments mentioned above are subject to ordinary income tax.
The Holding Period
To receive the lower tax rate for qualified dividends, the IRS requires that investors hold shares for a minimum amount of time. Common stock investors cannot hold shares for longer than 60 days within 121 days. This is the 60-day period before the ex-dividend day. On the date, after the dividend has been paid, new buyers will be eligible to receive future distributions. Prefer stock holders must hold the shares for more than 90 days within 181 days, which begins 90 days before the ex-dividend.
The holding requirements for mutual funds are slightly different. A mutual fund must hold the security unhedged at all times for at least 61 of the 121-day period that began at least 60 calendar days before the ex-dividend date. The applicable share must also have been held by investors simultaneously.
Example
A mutual fund X pays qualified dividends to an investor. The investor purchased 1,000 shares of fund X in May for the relevant tax year. The investor sold 100 shares of fund X on June 1, but he continued to own the remaining (unhedged) 900 shares. May 15 was the ex-dividend date of the fund.
The investor had 100 shares held for 31 days (from May 1 through June 1) and the remaining 900 shares at least 61 (from July 1 through July 1). The 900 shares held for at most 61 days (from May 1 through June 1) and the remaining 900 shares for at least 61 days would qualify as qualified dividend income. Unqualified dividend income would result from 100 shares being held for only 31 days. The investor could use the qualified dividend per stock price to calculate the exact amount of qualified dividends.
What It Means For Investors
Most everyday investors don't care about whether a dividend is qualified. This is because most dividends paid by U.S. companies are qualified. However, for investors primarily focused on foreign companies, REITs and MLPs, and other types of investment vehicles, the difference in qualifications and alternatives can make a significant impact when calculating taxes. However, investors can't do much to influence whether or not qualified dividends are considered qualified. An investor should hold stocks for the required minimum period, as the stock type specifies.
