The tax treatment of dividends in the U.S. depends on whether the Internal Revenue Code classifies them as "qualified dividends" or "ordinary dividends." (Ordinary dividends are also referred to as nonqualified dividends.) Qualified dividends are taxed at the same rates as the capital gains tax rate; these rates are lower than ordinary income tax rates.

The tax rates for ordinary dividends (typically those that are paid out from most common or preferred stocks) are the same as standard federal income tax rates, or 10% to 37% for the tax year 2020. Investors pay taxes on ordinary dividends at the same rates they pay on regular income, such as salary or wages. Income-tax and capital gains rates change over time, but in recent years, the latter have been substantially lower than the former.

Key Takeaways

  • The tax treatment of dividends in the U.S. depends on whether the Internal Revenue Code classifies them as "qualified dividends" or "ordinary dividends."
  • Qualified dividends are taxed at the same rates as the capital gains tax rate; these rates are lower than ordinary income tax rates.
  • The tax rates for ordinary dividends are the same as standard federal income tax rates, or 10% to 37%.

Qualified Dividends vs. Ordinary Dividends

A dividend is a portion of a company's earnings paid directly to shareholders. Companies that offer dividends pay a fixed amount per share and can adjust it up or down with each earnings period (usually a calendar quarter), based on how the company is doing. The investor must pay taxes on her dividends, but how much she pays depends on whether the dividends are qualified or ordinary.

Qualified dividends, which receive more favorable tax treatment, must meet a few criteria. They must be issued by U.S. corporations publicly traded on major exchanges, such as Dow Jones or NASDAQ. The investor must own them for at least 60 days out of a 121-day holding period. Certain dividends—such as those derived from an employee stock ownership plan or issued by a tax-exempt organization—are not eligible for qualified status.

There is no significant difference between qualified and ordinary dividends apart from their tax treatment.

Qualified-Dividend Tax Treatment

Investors favor qualified dividends because they are subject to lower tax rates, namely those levied on long-term capital gains rather than those charged on ordinary income. That's true regardless of the investor's tax bracket, though the biggest savings accrue to investors in the top two brackets, where the tax rate difference between the two types of dividends can be as much as 20%.

Currently, the tax schedule for qualified dividends features only three levels: 0%, 15%, and 20%. The maximum rate of tax on qualified dividends is 0% on any amount that otherwise would be taxed at a 10% or 15% rate, 15% on any amount that otherwise would be taxed at rates greater than 15% but less than 37%, and 20% on any amount that otherwise would be taxed at a 37% rate.

Individuals earning $200,000 or more, and married couples earning $250,000 more, pay an additional 3.8% on investment income, including qualified dividends.

Hypothetical Example

To see the difference these two tax treatments make, imagine an investor with 5,000 shares of Company X that generate a $2 each in ordinary dividends, or $10,000 a year. Assume he is single and has a taxable income of $50,000 a year, placing him in the 22% marginal income rate bracket for ordinary income. Since ordinary dividends receive no special tax treatment, he pays 22%, or $2,200, in taxes on his dividends. However, if his dividend is qualified, he pays a 15% rate, based on his income, or $1,500.

Imagine the same investor, still single, earns taxable income of $1 million per year, excluding dividends from 50,000 shares of Company X stock. At $2 per share, his yearly dividend is $100,000. Taxed at the 37% top marginal rate, he owes $37,000 in federal taxes on the dividends if they're ordinary, but only $20,000 if they are qualified, a $17,000 savings.