Dividends receive different tax treatment based on whether the United States Internal Revenue Code classifies them as qualified or nonqualified. Qualified dividends are taxed at the same rates as long-term capital gains; these rates are lower than ordinary income rates and, as of 2016, do not exceed 20%. Nonqualified dividends are taxed as ordinary income, which, depending on the tax bracket, could mean a rate as high as 39.6%.
Qualified vs. Nonqualified 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 this amount up or down, based on how the company is doing. Consider an investor who owns 5,000 shares of Company X stock, which pays a dividend of $2 per share. The investor, then, receives $10,000 in dividend payments for the year. In most cases, dividends are paid quarterly, so this particular investor would receive $2,500 every three months. The $2 figure is not set in stone; the company may run into hard times and reduce its dividend, or it might increase it after a great year of earnings.
Unfortunately, the investor has to pay taxes on his or her dividend payments. How much the investor pays depends on whether the investor's dividends are qualified or nonqualified. 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. Additionally, the investor must own them for at least 60 days out of a 121-day time frame, known as the holding period. Certain characteristics can exclude dividends from being qualified, such as if they are part of an employee stock ownership plan (ESOP), or if they are issued by a tax-exempt organization.
All dividends not meeting the criteria to be qualified are known as ordinary dividends, or nonqualified dividends. Little to no difference exists between qualified and nonqualified dividends as to how they are paid out. Their primary dissimilarity is tax treatment.
Qualified Dividend Tax Treatment
Investors often gravitate toward qualified dividends because they are subject to lower taxes, as these dividends are taxed at the rate of long-term capital gains rather than that of ordinary income. Lower tax rates apply to qualified dividends versus nonqualified dividends, regardless of the tax bracket that the investor is in. However, the most substantial savings accrues to investors in the top two brackets, where the tax rate difference between the two types of dividends can be as much as 20%.
As of 2016, the tax schedule for qualified dividends features only three levels: 0, 15 and 20%. Investors in the bottom two tax brackets are fully exempt from paying taxes on qualified dividends. With a tax rate of 0%, this means that low-income investors can keep all the money that they make through this investment vehicle. For all other investors, the tax rate for qualified dividends is 15%, with the exception of those in the highest tax bracket, who pay 20%. As of 2016, this tax bracket was comprised of single filers who earn $415,050 or more, and married filers who earn a combined $466,950 or more.
Additionally, a person earning $200,000 or greater, or a married couple earning $250,000, pays an additional 3.8% on investment income, including qualified dividends.
Nonqualified Dividend Tax Treatment
Investors are required to pay taxes on income earned from nonqualified dividends at the same rates that they are taxed on ordinary income, such as salary or wages from work. Both ordinary income tax rates and long-term capital gains rates change over time, usually based on the political climate and the nation's budgetary needs. For all of recent history, however, ordinary income rates have been higher across the board.
The tax rates for ordinary income, including nonqualified dividends, ranges from 10 to 39.6% as of 2016. The income breakdown for these rates is as follows:
10%: Single filers earning less than $9,275 and married filers earning less than $18,550.
15%: Single filers earning from $9,275 to $37,650 and married filers earning from $18,550 to $75,300.
25%: Single filers earning from $37,650 to $91,150 and married filers earning from $75,300 to $151,900.
28%: Single filers earning from $91,150 to $190,150 and married filers earning from $151,900 to $231,450.
33%: Single filers earning from $190,150 to $413,350 and married filers earning from $231,450 to $413,350.
35%: Single filers earning from $413,350 to $415,050 and married filers earning from $413,350 to $466,950.
39.6%: Single filers earning more than $415,050 and married filers earning more than $466,950.
Based on the above numbers and how they correspond with qualified dividend tax rates, the lowest possible tax savings on qualified dividends is 10%, and the highest is 20%.
Let us return to the above example of the investor with 5,000 shares of Company X stock that each earn him $2 in dividends, for a total of $10,000 in dividend income per year. Also assume that he is single and earns $50,000 per year, placing him in the 25% tax bracket for ordinary income. Since nonqualified dividends do not receive special tax treatment, the investor pays 25%, or $2,500, in taxes on his dividend if it is nonqualified. However, if his dividend is qualified, that means he pays a 15% tax rate on it, based on his income. His tax liability on the dividend, then, is $1,500. This investor, whose income is close to the U.S. median, saves 10%, or in this scenario, $1,000, by having qualified dividend stock as opposed to nonqualified dividend stock.
Now consider the same investor, still single, but instead of an average American income-wise, he is a Silicon Valley entrepreneur earning $1 million per year. Also assume that because he is so rich, he can afford 50,000 shares of Company X stock instead of only 5,000. Therefore, his yearly dividend is $100,000. Taxed at his ordinary income rate of 39.6%, this means that he gives up $39,600 to the government each year if the dividend is nonqualified. His qualified dividend rate is 20%, which means he owes $20,000 in taxes for a qualified dividend of the same amount. His savings of 19.6%, which totals $19,600 in this scenario, is material, even for a wealthy Silicon Valley hotshot.