Qualified Dividend

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Last Updated:December 4, 2023

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What Are Qualified Dividends?

Qualified dividends are dividend payments taxed at the long-term capital gains rate, which is lower than the ordinary income tax rates.

A company issues a reward, cash or otherwise, in the form of “dividends.” It distributes a portion of the company’s earnings among the shareholders.

They're paid regularly per share of stock. For example- if you own 30 shares in a company and that company pays $2 in annual cash dividends, you will receive $60 per year.

They are one way that stock investors might profit from their investments. It offers a stream of income that is steady and expanding. They favor investing in businesses that provide dividends that rise annually to outpace inflation.

If you receive a dividend, you'll most likely have to pay taxes on it. But how much you pay in taxes will depend on whether the payout is qualified or non-qualified.

Before we move forward to find out if the dividend received by us is qualified or non-qualified and how much tax we need to pay on such dividends, we must first understand what qualified dividends are.

These dividends are subject to capital gains tax rates (which depend on the investor’s modified adjusted gross income (AGI) and taxable income) that are lower than the income tax rates on unqualified or ordinary dividends.

Generally speaking, these are dividends from shares of domestic firms and some qualified foreign corporations that you have held for at least a specified minimum time or holding period.

The shares must also be unhedged, meaning that during the holding period, there were no short sales, puts, or calls associated with the shares.

Ordinary dividends are taxed at the same basic federal income tax rates, which for tax years 2021 and 2022 range from 10% to 37%. In contrast, depending on the tax bracket, these dividends are taxed as capital gains at 20%, 15%, or 0%.

On IRS Form 1099-DIV, a tax document distributed to investors who receive distributions during the calendar year from any investment, such dividends are listed in box 1b.

Criteria for a Dividend to be “Qualified”

For a dividend to be called “qualified," certain conditions must be met. These include:

1. Qualifying Foreign Companies

It was paid either by a U.S. corporation or a qualified foreign corporation. A foreign corporation qualifies for special tax treatment if it meets one of the following three conditions:

the company was incorporated in a U.S. possession
the corporation is eligible for the benefits of a comprehensive income tax treaty with the United States
or the stock is readily tradable on an established securities market in the United States (e.g., an American Depositary Receipt or ADR).

A foreign corporation categorized as a passive foreign investment company is ineligible.

2. Dividends That Do Not Qualify

Dividends not included under "Dividends that are not qualified dividends" are given on page 20 of the Internal Revenue Service's Publication, 550 - Investment Income and Expenses.

They can be regarded as QDs and are taxable at the capital gains rate.

The dividends that are exempt from consideration as QDs are as follows:

Dividends paid by real estate investment trusts (REITs), master limited partnerships (MLPs)
Dividends on employee stock options and those of tax-exempt companies
Dividends paid from money market accounts, such as deposits in savings banks, credit unions, or other financial institutions, do not qualify and should be reported as interest income.
Special one-time dividends are also unqualified.
QDs must come from shares not associated with hedgings, such as those used for short sales, puts, and call options.

It's important to note that being a corporation requires qualified dividends.

3. The Holding Period

For these dividends to benefit from the lower tax rate, the IRS mandates that investors hold shares and mutual funds for a minimum period.

In the case of Common Stock: Common stock investors must hold the shares for more than 60 days during the 121-day period that starts 60 days before the ex-dividend date. Or it can be the date after the dividend has been paid out, after which any new buyers would be eligible to receive future dividends.
In the case of Preferred Stock: For preferred stock, the holding period is more than 90 days during a 181-day period that starts 90 days before the ex-dividend date.
C. In the case of Mutual Funds: The fund must have held the security unhedged for at least 61 days out of the 121-day period that began 60 days before the security’s ex-dividend date. Investors must have held the applicable share of the mutual fund for the same period.

An example of determining the holding period

Consider the following hypothetical situation: You have dividends listed on Form 1099-DIV as qualified from shares in the XYZ fund. In the tax year, on April 27, you bought 10,000 shares of the XYZ fund.

On June 15, you sold 2,000 of those shares, leaving you with 8,000 shares that you hold (unhedged). For the XYZ fund, May 2 marked the ex-dividend date.

Therefore, between April 28 and June 15, when the 121-day window was open, you held 2,000 shares for 49 days and 8,000 shares for at least 61 days (from April 28 through July 1).

The 2,000 shares' dividend income would not qualify as QDs income after being held for 49 days. The dividend income from the 8,000 shares held for at least 61 days should be QD income.

The ex-dividend date is the date the stock will trade without its dividend rights, meaning the previous owner will be entitled to the next dividend payment.

For dividends that do not meet the above criteria, the tax is determined by the date when the dividend was paid and the individual's ordinary income tax bracket.

Qualified Dividend Tax Rate – 2020 Tax Year

Dividends are typically considered to be taxable income, not free money. However, the dividend tax rate you pay can be significantly altered by how and when you own an investment that distributes it.

There are numerous exceptions and unique situations that have specialized rules. As discussed earlier, the tax rate on qual divs is 0%, 15%, or 20%, depending on your taxable income and filing status.

The tax rate on non-qualified dividends is the same as your regular income tax bracket. In both cases, people in higher tax brackets pay a higher dividend tax rate.

These rates apply to QDs, based on taxable income, for the tax return you'll file in April 2023.

The tax rate slab given below is only applicable in the United States. It is differentiated based on taxable income and the status of a person for the financial year 2023.

Tax Slab
Tax-filing status	Single	Married, filing jointly	Married, filing separately	Head of household
0%	$0 to $41,675	$0 to $83,350	$0 to $41,675	$0 to $55,800
15%	$41,676 to $459,750	$83,351 to $517,200	$41,676 to $258,600	$55,801 to $488,500
20%	$459,751 or more	$517,201 or more	$258,601 or more	$488,501 or more

Unqualified Dividends vs. Qualified Dividends

A dividend must be paid by a U.S. corporation, a foreign company doing business here, or a country with which we have a tax treaty for it to qualify.

To reward patients and long-term owners, a tax cut was created. Therefore, to be eligible, you must hold the shares for a minimum holding period, as mentioned above, according to the type of shares or mutual fund held.

Ordinary dividends are expensive for investors because they are taxed at income tax rates. A qualified premium, on the other hand, costs less to investors and is taxed at the capital gains rate.

Therefore, it is less beneficial for investors as a higher tax is payable and lower savings. The eligible dividend is, therefore, more beneficial for investors since a lower tax is payable.

Ordinary dividend tax rates range from 0% to 39.6%. Thus, it doesn't appear to be in the investors' best interests. In contrast, QDs are subject to lower tax rates ranging from 0% to 20%.

The ordinary dividend has no qualifying requirements because investors must pay taxes according to their individual tax brackets, and no exemption is granted for regular dividend income.

Contrarily, the eligible dividend must satisfy eligibility requirements, such as holding time and payment requirements.

Qualified Dividend Tax Treatment

Ordinary dividends are taxed like regular income, whereas QDs are taxed at the same rate as long-term capital gains.

This was done to encourage corporations to pay higher dividends to their long-term shareholders and to encourage investors to hold onto their stocks for longer to benefit from these dividend payments.

Investors prefer QDs because they are subject to lower tax rates—specifically, those based on long-term capital gains as opposed to ordinary income from unqualified dividends.

That holds true regardless of the investor's tax bracket, though investors in the top two brackets will save the most money because there can be a 20% tax rate difference between the two types of dividends.

The Internal Revenue Service Form 1099-DIV has separate boxes for reporting qualified and ordinary dividends. QDs are recorded in box 1b, and total ordinary dividends are given in box 1a.

Both qualified and non-qualified dividends are included in ordinary dividends. However, the IRS distinguishes between them on tax returns by subtracting QDs from all ordinary dividends, with non-qualified dividends implicitly making up the difference.

Implications for Retirement Account

You can save money for retirement tax advantageously with an individual retirement account (IRA).

An IRA is a financial institution-created account that enables someone to save for retirement while earning tax-free growth or on a tax-deferred basis. Its advantages are as follows:

Supplement your current savings in your employer-sponsored retirement plan
Gain access to a wider range of investment choices than your employer-sponsored plan
Take advantage of potential tax-deferred or tax-free growth

People who include dividend-paying stocks in their retirement investment accounts, such as 401(k) accounts, do not pay taxes on dividends until they begin taking distributions on the funds.

Retirement accounts can nullify the impact of taxes on dividends. For pre-tax retirement accounts like a 401(k) and Traditional IRA, all taxes are deferred until withdrawal. At this point, only ordinary income taxes will be applied, and the annual taxes on dividends will be avoided.

People with Roth IRAs enjoy the greatest tax benefit because distributions from the accounts are typically tax-free, assuming the account holder follows the rules for Roth IRA distributions.

In the case of a Roth IRA, those conditions are that you are 59.5 years old and have had the account for at least five years.

Qualified Dividends and Gross Income

Gross income-less adjustments to income are known as adjusted gross income (AGI). Your salary, dividends, capital gains, company revenue, retirement payouts, and other sources of income are all included in your gross income.

Adjustments to income can be provided for things like tuition costs, interest on student loans, alimony payments, or contributions to retirement accounts. The AGI may typically be lower and can never exceed your total gross income on your tax return.

The normal treatment of dividends received is as follows: dividends received from a state or national bank or mutual building and loan association are taxable. Therefore, they should be included in the gross income of the taxpayer.

Q Dividend income, however, is subject to the capital gains tax rate rather than your income tax rate, which is higher. Q dividends are thus included in a taxpayer's adjusted gross income.

Although all dividends given to shareholders must be included in their gross income, qual divs are treated more favorably under taxation, i.e., at a lower rate than ordinary dividend income.

What It Means for Investors

The biggest advantage of QDs is that they qualify for the lower long-term capital gains tax rate.

As previously noted, the difference in the tax burden can be substantial. For example, let's say you're in the 28% income tax bracket and received $2,000 in dividends this year.

If these dividends were qual divs, you'd pay taxes at a rate of 15%, which would come to $300. However, if these were non-qualified ordinary dividends, you'd pay taxes on them at a 28% rate -- producing a tax bill of $560.

In short, owning stocks that pay QDs could cut your taxes on those dividends almost in half.
Thus, the QD is very beneficial from the investors’ point of view, as they can save more money by paying lower taxes on their dividend income.

The intention is that the government wants investors to hold stocks for longer, not just for tax-saving purposes.

Thus the tax concession on the dividend income can only be availed by the investors who are investing in the stocks of companies for the longest time and have no intention to trade it in a shorter period.

Due to this tax concession facility, many people are attracted to investing their money in stocks instead of elsewhere. This will help to grow the financial market.

For most everyday investors, whether a dividend will be qualified or not is usually a non-issue. This is because most regular dividends from U.S. corporations are considered qualified.

Nonetheless, particularly for those investors focused on foreign companies, REITs, MLPs, and other types of investment vehicles indicated above, the difference between qualification and the alternative can be significant when it comes time to calculate taxes.

On the other hand, there isn’t much that an investor can do to have a bearing on whether or not dividends will be considered qualified. Instead, an investor can take the most important action to hold stocks for the minimum holding period.