Posted by Jim McClaflin, EA, NTPI Fellow

What Are Qualified Dividends?

What Are Qualified Dividends?

There exist two kinds of dividends, qualified and ordinary dividends. Ordinary dividends are taxed at the income tax rate, and qualified dividends are taxed at a lower special rate.

As of fiscal 2020, the tax rate on qualified dividends is 0%, 15%, or 20%, depending on the tax category in which the investor falls, which can range from 10% to 37% as of 2020.


What is a qualified dividend?

To be deemed a qualified dividend, a dividend must meet certain requirements set by the Internal Revenue Service (IRS). A qualifying U.S. or foreign corporation must have paid dividends and must not be listed with the IRS as unqualified dividends. In addition, the mandatory minimum retention period for dividends must be met. Typically, there are 61 days for common shares and 91 days for preferred shares.

In order for their dividends to be considered qualified dividends, foreign corporations must meet one of the three requirements. They must be registered in the United States, be qualified for the benefits of a comprehensive tax treaty with the United States, or be readily traded on an established U.S. stock exchange.


Which dividends do not qualify?

Certain dividends are automatically excluded from qualified dividends. These dividends include those paid by real estate investment funds and limited partnerships. Excluded dividends also include those paid for employee stock options and tax-exempt corporations.

In addition, dividends paid from money market accounts or other financial institutions are recorded as interest income rather than qualified dividends. In addition, one-time special dividends are not classified as qualified dividends. Finally, qualified dividends must be paid for shares that are not used for hedging purposes, such as those that are sold short and call and put options.


Qualified Dividends vs. Ordinary Dividends 

The biggest difference between qualified and ordinary dividends is the tax rate. Qualified dividends are taxed at the lower capital gains tax rate, as mentioned above, while ordinary dividends are taxed at a higher rate. Both types of dividends are charged based on the tax category the investor is in.

The other difference between these two types of dividends is that dividends must meet certain requirements to be considered qualified. Qualified dividends are paid by an eligible U.S. or foreign corporation that the IRS does not list as non-qualified dividends and held for a specified minimum period, typically sixty-one days for common stock and ninety-one days for preferred stock.


How are qualified dividends taxed?

The tax rate for qualified dividends is the capital gains tax rate, which ranges from 0% to 20%, depending on the tax interval in which the investor falls.

Ordinary dividends are taxed at the investor's income tax rate, depending on their tax category. In 2020, income tax ranged from 10% to 37%, depending on income. These taxes are subject to change from year to year and are shown in the tax return instructions for each year.

It is important to consider how they will be taxed when buying stocks with dividends, as the tax rate can make a big difference in how much tax is charged.


Upsides and downsides of qualified dividends

The big advantage of qualified dividends is the lower tax rate. The difference between the long-term capital gains tax rate and the income tax rate can be significant, although both depend on the level of taxation the investor is in.

One downside to qualified dividends is that you have to hold them for a period of time for them to benefit from the lower tax rate. It can be confusing for first-time investors to figure out when they need to own stocks for their dividend to be considered a qualified dividend.


The retention period for qualified dividends

As mentioned above, the minimum dividend retention period is usually 61 days for common shares and 91 days for preferred shares. All stocks must remain unhedged, which means they are not hedged with options.

In the case of shares belonging to a mutual fund, there is an additional requirement. First, the fund must hold unhedged common stocks for at least 61 out of 121 days from 60 days before the ex-dividend date. Certain preferred shares must be held for at least 91 days out of the 181 days beginning 90 days before the ex-dividend date. In addition, investors must hold the applicable fund units for at least 61 out of 121 days from 60 days before the fund's ex-dividend date.


Example of qualified dividend

Since the holding period can be difficult to control, here is an example of how a qualified dividend works. An investor buys 10,000 shares of a company on April 27 and sells 2,000 shares on June 15. All stocks are held unhedged at any time during the period. The ex-dividend date for the company was May 2.

This means that during the 121 days, the investor holds 2,000 shares for 49 days between April 28 and June 15 and 8,000 shares for more than 60 days between April 28 and July 1. Dividend income from 8,000 shares would be considered a qualified dividend, but dividends paid on the other 2,000 shares would be taxed as ordinary dividends at the income tax rate.

In this example, multiply the number of qualified shares by the dividend amount per share to determine the valid dividend amount. If the dividend is 10 cents per share, the qualified dividend amount would be $800, while the ordinary dividend amount is $200.


Conclusion

In conclusion, qualified dividends are those that meet certain requirements. They must be from a qualified U.S. or foreign corporation, and the corporation type cannot be on the IRS's list of corporation types excluded from qualified dividends.

Investors must also adhere to the required minimum holding period, usually 61 days for common shares and 91 days for preferred shares. The 61-day holding period should be in the range of 121 days, starting 60 days before the ex-dividend date for ordinary stock, while the 91-day holding period for preferred stock should be 181 days from 90 days before the expiration date of the dividend.


FOR MORE INFORMATION ON HOW JIM McCLAFLIN, EA, NTPI FELLOW CAN BEST HELP YOU WITH YOUR TAX FILING NEEDS, PLEASE CLICK THE BLUE TAB ON THIS PAGE.


THANKS FOR VISITING.

Jim McClaflin, EA, NTPI Fellow
Contact Member