Dividends paid to investors by corporations come in two kinds – ordinary and qualified – and the difference has a large effect on the taxes that will be owed. Ordinary dividends are taxed as ordinary income, meaning a investor must pay federal taxes on the income at the individual’s regular rate. Qualified dividends, on the other hand, are taxed at capital gain rates. Lower-income recipients of qualified dividends may owe no federal tax at all. A financial advisor can help you find an assortment of securities that best meets your needs.
Dividends from owning shares of 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 some sources, including real estate investment trusts (REITs) and money market funds, are generally classified as ordinary dividends no matter how long they have been in a portfolio.
Qualified Dividend Background
Before 2003, all dividends were ordinary dividends and recipients paid taxes on them at their usual individual marginal rate. However, the tax cut law enacted that year set up a new exception for qualified dividends as a way to encourage companies to pay dividends on their shares. Since then, the opportunity to get favorable tax treatment has made dividends a bigger focus for both companies and investors.
Qualified Dividends
Regular dividends paid on shares of domestic corporations are generally qualified as long as the investor has held the shares for a minimum period. The Internal Revenue Service rule says the shares have to be owned for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. For preferred shares, the stock must be owned more than 90 days during the 181 days starting 90 days before the ex-dividend date.
The ex-dividend date is the earliest date after a dividend is declared that a buyer of the won’t be entitled to get the declared dividend. The shares also have to be unhedged during the holding period. This means the investor can’t have used any short sales, puts or calls involving the shares during the holding period.
If the dividends meet the definition for qualified, then the investor would owe no more than 20% tax on the income. That top rate only applies to high-income filers whose marginal tax rate is the maximum 37%. Filers whose marginal rate is less than 37% but at least 15% would owe 15%. Files whose income would be taxed at 10% or 15% would owe no federal income tax.
Ordinary Dividends
Most dividends from a corporation or mutual fund are ordinary dividends and are taxed like ordinary income, at the investor’s usual marginal tax rate. There are some businesses whose dividends are treated differently and their dividends are always or nearly always classified as ordinary income.
These dividend payers include:
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Money market funds
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Banks, thrifts and similar institutions paying interest on deposits
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Real estate investment trusts
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Employee stock ownership plans
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Foreign corporations
1099-Div
It’s not necessary for taxpayers to figure out for themselves which dividend are ordinary and which are qualified. Dividend payers do this for them and report the information to taxpayers as well as the IRS using the 1099-Div form.
For planning purposes, it’s still a good idea for investors to have an idea in advance whether dividends will be treated as qualified or ordinary. For instance, it’s often a good idea to keep securities that generate ordinary dividends in a tax-advantaged account such as an IRA or 401(k).
Bottom Line
The IRS rules regarding classification of dividends as ordinary or qualified are complicated and it can be difficult for dividend investors to tell, before receiving a 1099-Div form, how their income from dividends 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 time an investor has owned a security helps to determine whether its dividends will be regarded as ordinary or qualified. Generally speaking, if a stock has been owned for more than a few months, its dividends are likely to be qualified. The exceptions include securities of certain dividend payers, such REITs and money market funds.
Tips for Investing
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A financial advisor can help you determine whether a dividend will be classified as qualified or ordinary and provide advice about how to manage taxes that will be owed on the income. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
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Income in America is taxed 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 what you owe Uncle Sam.
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