Qualified Dividends: How Do They Work

Qualified Dividends: How Do They Work

Investors that receive dividends from their stocks are getting a share of a company’s profits. This is because they are a type of income. However, qualified dividends are taxed at a lower rate than ordinary dividends because they meet specific criteria. This difference is a significant advantage to investors.

Intelligent investors can build a passive income stream and live from dividends. Moreover, the income stream is efficient because it is taxed at the lower qualified dividend rate, which is the capital gains rate.

What are Qualified Dividends?

Dividend tax rates differ because it depends on whether they are qualified, which are taxed at a lower capital gains rate as opposed to the ordinary income tax rate. Ordinary dividends are also known as non-qualified dividends. Today, qualified dividends are taxed at 0%, 15%, and a maximum of 20%, depending on your income and tax bracket.

A qualified dividend must meet specific criteria defined by the Internal Revenue Service (IRS).

Criteria for Qualified Dividends

In order to be deemed a qualified dividend, it must meet the following requirements:

• Paid by a U.S. company or a company in a U.S. possession.
• Paid by a foreign company residing in a country eligible for benefits under a U.S. tax treaty.
• Paid by a foreign company that can be easily traded on a major U.S. stock market.
• The stock must have been held for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date.
• For preferred stock, the stock must be held for more than 90 days during the 181-day period before the ex-dividend date.
• It cannot be a type of dividend listed by the IRS as dividends that are not qualified even if the holding period and other criteria are met.

Example

The IRS provides example scenarios. We also offer one here to help you understand the concept.

Suppose you purchased 1,000 shares of ABC Company stock, a United States company, on January 3, 2023. The company is not a REIT or an MLP. Instead, the company paid a quarterly cash dividend of $0.50 per share with an ex-dividend date of March 20, 2023.

Because ABC Company is headquartered in the U.S. and the dividends are not ordinary, the criteria for qualified dividends are almost met. We must only check the holding period. In this case, the 60 days before the ex-dividend date is January 20, 2023. The 121-day holding period ends on May 20, 2023. You meet the holding period requirement, and thus the dividends meet the criteria.

In a variation of this example, we assume the company is Canadian and trades as an American Depository Receipt (ADR) on the New York Stock Exchange (NYSE). In this case, the dividends are still qualified, assuming the holding period is the same.

Qualified vs. Ordinary Dividends

Dividends that are not qualified are referred to as ordinary or non-qualified dividends. The primary difference between the two is the tax rate. Qualified dividends have three tax rates 0%, 15%, and a high of 20%, the same as long-term capital gains. On the other hand, ordinary dividends are taxed as ordinary income, ranging from 10% to 37%. As a result, a high-income earner at the maximum ordinary tax rate pays 37% on a W-2 salary but 20% on dividends meeting the criteria, an enormous difference.

Another crucial difference is that ordinary dividends are more common. Besides ownership of stocks, mutual funds, and exchange-traded funds (ETFs) that do not meet the criteria to be considered qualified, other categories exist. Examples include master limited partnerships (MLPs), real estate investment trusts (REITs), and other pass-through entities. 

In addition, interest from savings accounts, money market accounts (MMAs), certificates of deposit (CDs), and U.S Treasury bills and bonds are taxed at your regular rate.

Qualified and non-qualified dividends are reported on a 1099-DIV un line 1b. But the total dividends are found in line 1a.

History of Qualified Dividends

Qualified dividends are a relatively new concept in investing. Dividends were historically taxed at the income rate. In the United States, that changed in 2003 because lawmakers felt companies favored share repurchases instead of paying dividends.

Jobs and Growth Tax Relief Reconciliation Act of 2003

In America, tax cuts called the Jobs and Growth Tax Relief Reconciliation Act of 2003 were signed into law. Before this law was passed, all dividends were taxed at income rates. 

But the new law lowered all taxpayers’ personal income tax rates. It also created a new class of dividends, the qualified dividends, taxed at the long-term capital gains tax rate. Furthermore, the long-term maximum capital gains tax was reduced to 15% from 20%. Also, a tax rate of 5% was established for taxpayers in the lowest income tax brackets of 10% and 15%. At this time, the two qualified dividend tax rates were 5% and 15%.

Tax Increase Prevention and Reconciliation Act of 2005

The new class of qualified dividends and tax rates had expirations. However, Congress passed a second law, the Tax Increase Prevention and Reconciliation Act of 2005, preventing the provisions from taking effect. Additionally, the law cut the 5% tax rate to 0% on the two lowest income tax brackets. At this time, the two qualified dividend tax rates were 0% and 15%.

Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010

In 2010, the United States Congress passed another law pushing the expiration date out two more years.

The American Taxpayer Relief Act of 2012

Finally, the American Taxpayer Relief Act of 2012 was passed, making qualified dividends a permanent part of the United States tax code. The law took effect on January 1, 2013. The law also added one more tax bracket of 20% for qualified dividends. Additionally, it created a maximum 39.6% regular income tax bracket, which was later lowered to 37%.

Since 2012, the three qualified dividend tax rates were 0%, 15%, and a maximum of 20%. Consequently, their tax rate is permanently lower than the ordinary income tax rate in a tax bracket.

Are Qualified Dividends a Success?

Passing laws to create a qualified dividend tax rate equal to the long-term capital gains tax rate should have benefitted income investors. One change from the new regulations was that many tech companies started to pay dividends. However, many some tech and high-growth companies still do not. For example, Tesla does not pay dividends. Moreover, it is unlikely to do so, based on statements by Elon Musk, because instead of dividends, he sells stock to pay for expenses.

The Bottom Line

The main advantage is investors pay a lower tax rate. For instance, suppose you and your wife are in the 24% income tax bracket but in the 15% long-term capital gains one for dividends. A $50,000 W-2 income causes a $12,000 federal tax bill. However, the same $50,000 in qualified dividends only results in $7,500 in taxes, almost half. Consequently, receiving qualified dividends is tax efficient and lets you keep more retirement money.

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Published at Fri, 14 Apr 2023 04:00:00 -0700