What is the difference between qualified dividends and ordinary dividends

What are Dividends?

When a company has excess cash that it cannot—or does not want to—reinvest in itself, it distributes this money to its owners i.e., shareholders. This cash distribution is called a dividend.

What are Ordinary Dividends?

Pretty much all dividends are ordinary dividends. IRS Publication 550, Investment Income and Expenses says this about ordinary dividends:

Ordinary dividends are the most common type of distribution from a corporation or a mutual fund. They are paid out of earnings and profits and are ordinary income to you. This means they are not capital gains. You can assume that any dividend you receive on common or preferred stock is an ordinary dividend unless the paying corporation or mutual fund tells you otherwise. Ordinary dividends will be shown in box 1a of the Form 1099-DIV you receive.

What are Qualified Dividends?

Some ordinary dividends are also qualified dividends. When dividends meet certain criteria, they are called qualified dividends because they qualify to be taxed at a lower rate—the capital gains tax rate—rather than the ordinary income tax rate.

One of the Bush tax cut bills was the JGTRRA (Jobs and Growth Tax Relief Reconciliation Act) passed in 2003). This law established the concept of—and criteria for—qualified dividends, and was the first time there was a lower rate for dividends than the ordinary income tax rate. Over the years, the specific rates and tax brackets have fluctuated but the core concept has stayed the same.

Rationale for a lower tax rate

Dividends are paid by corporations to shareholders to distribute some of the earnings (profit) of the company. These profit distributions are made from the company's after-tax income. i.e., companies pay income tax on their profits; the cash remaining after paying the corporate income tax is distributed to shareholders (because they are the owners of the company).

When individual shareholders receive this distribution, this is considered part of their income and is subject to income taxes. So this is double taxation of company profits—once when the company is taxed on income, and later when the individual shareholder is taxed on dividends distributed to them.

Given the double taxation occurring in the process, it makes sense to tax dividends at a lower rate (or not at all, as some critics and economists have argued). Qualified dividends aim to partially compensate for this double taxation.

Qualified Dividends Criteria

Income tax rules describe eligibility criteria for qualified dividends. The rationale behind these criteria has two components: that the company should have U.S. ties (so the dividends are from income that has already been taxed), and that the recipient is an investor shareholder rather than a speculator.

The criteria for qualified dividends are:

1. The dividends must have been paid by a U.S. corporation or a qualified foreign corporation.
2. The dividends are not listed specifically under the IRS's list of dividends that are not qualified.
3. You meet the holding period requirements.

Let's look at each of the criteria in detail.

Holding period

For dividends to be qualified, you must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. The ex-dividend date is the first date following the declaration of a dividend on which the buyer of a stock is not entitled to receive the next dividend payment.

When counting the number of days you held the stock, include the day you disposed of (sold) the stock, but not the day you acquired it.

The holding period requirements are a little different if the stock for which you are receiving dividends is preferred stock, and if the preferred dividends are due to periods greater than 366 days. For those scenarios, you must have held the stock more than 90 days during the 181-day period that begins 90 days before the ex-dividend date.

Dividends that are never qualified

The following dividends are not qualified dividends, even if they are shown in box 1b of Form 1099-DIV.

• Capital gain distributions.
• Dividends from a corporation that is a tax-exempt organization or farmer's cooperative during the corporation's tax year in which the dividends were paid or during the corporation's previous tax year.
• Dividends on any share of stock to the extent you are obligated (whether under a short sale or otherwise) to make related payments for positions in substantially similar or related property.
• Dividends paid by a corporation on employer securities held on the date of record by an employee stock ownership plan (ESOP) maintained by that corporation.
• Dividends paid on deposits with mutual savings banks, cooperative banks, credit unions, U.S. building and loan associations, U.S. savings and loan associations, federal savings and loan associations, and similar financial institutions. Report these amounts as interest income.
• Payments in lieu of dividends, but only if you know or have reason to know the payments are not qualified dividends.
• Payments shown on Form 1099-DIV, box 1b, from a foreign corporation to the extent you know or have reason to know the payments are not qualified dividends.

Qualified Foreign Corporation

A qualified foreign corporation is a foreign company that meets any one of the following conditions:

• The corporation is incorporated in a U.S. possession.
• The corporation is eligible for the benefits of a comprehensive income tax treaty with the United States that the Department of the Treasury determines is satisfactory for this purpose and that includes an exchange of information program. For a list of those treaties, see this IRS Table.
• The stock for which the dividend is paid is readily tradable on an established securities market in the United States.

Tax Rates

The main advantage of qualified dividends is the lower tax rate. Here is a table that shows the tax rate for ordinary vs. qualified dividends for people in various tax brackets:

* The +3.8% surcharge is due to the NIIT (Net Investment Income Tax), a surcharge that was put in place on investment income as part of the Affordable Care Act (Obamacare). It applies to single filers with an AGI > $200,000, and married filing jointly with AGI > $250,000.

As the table shows, no matter what tax bracket you are in, taxes are always lower for qualified dividends than for ordinary dividends. The higher your tax bracket, the greater your savings from dividends being qualified.

Filing Taxes

While some of the eligibility criteria may seem complex, the good news is that individual investors rarely need to worry about figuring out whether the dividends they received are qualified. The company distributing the dividends is required to make that determination.

The year-end 1099-DIV form that you get from your stock brokerage explicitly specifies what portions of your dividends are ordinary and qualified. On a 1099-DIV, qualified dividends are in Box 1b and the total of all ordinary dividends—including qualified dividends—are in Box 1a.

When filing your taxes using an online service like TaxAct or TurboTax, they will either import your 1099-DIV directly from your broker or you can enter the information yourself. Because the amount of qualified dividend is clear on Box 1b, you likely will not have to figure the amount yourself. Exceptions to that would be when you use multiple brokers and open options trading positions in the same stocks for which you have received qualified dividends.

Some dividends are not reported on 1099-DIV. e.g., if you have ownership stake in a partnership or S corporation, dividends from them will be reported by the company to you on Schedule K-1, which is part of the income tax return filed by the partnership (Form 1065) or S-Corp (Form 1120S).

References

• Qualified Dividends - IRS.gov
• Qualified dividend - Wikipedia

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