Though most dividends paid out by corporations or mutual funds to shareholders are considered ordinary dividends, some may be considered qualified dividends. In these cases, your dividend income is subject to the capital gains tax rate rather than your income tax rate, which is higher. Qualified dividends are thus included in a taxpayer's adjusted gross income; however, these are taxed at a lower rate than ordinary dividends.

Key Takeaways

  • All dividends paid to shareholders must be included on their gross income, but qualified dividends will get more favorable tax treatment.
  • A qualified dividend is taxed at the capital gains tax rate, while ordinary dividends are taxed at standard federal income tax rates.
  • Qualified dividends must meet special requirements put in place by the IRS.
  • The maximum tax rate for qualified dividends is 20%; for ordinary dividends for the 2020 calendar year, it is 37%.

Ordinary Dividends Versus Qualified Dividends

Qualified and unqualified dividends may have differences which appear to be minor, but they have a significant impact on overall returns. Overall, most regular dividends distributed by companies in the U.S. are qualified. The biggest difference between qualified and unqualified dividends as far as their impact come tax time is the rate at which these dividends are taxed. Unqualified dividends are taxed at an individual’s normal income tax rate, as opposed to the preferred rate for qualified dividends as listed above. This means that individuals occupying any tax bracket will see a difference in their tax rates depending upon whether they have qualified or ordinary dividends.

To be considered a qualified dividend, a dividend must be paid by an American corporation or a qualified foreign entity. In addition, you must have held the stock for which the dividend was paid for at least 60 days within the 121-day period that ends 60 days prior to the ex-dividend date. If the ex-dividend date is Dec. 1, for example, then you must have owned the stock for at least 60 days during the period between June 3 and Oct. 2.

Taxation and Dividends

According to the Internal Revenue Service (IRS), ordinary dividends are paid out of a corporation or mutual fund's earnings and taxed at the same rate as ordinary income. These payouts are shown in box 1a of Form 1099-DIV, which is sent to investors.

Qualified dividends are similar to ordinary dividends but are subject to the same 0%,15% or 20% rates that apply to long-term capital gains. Your qualified dividends will appear in box 1b of Form 1099-DIV. The maximum rates are:

  • 0% if your ordinary income is taxed at 10% or 15%
  • 15% if you are taxed at a rate greater than 15% but less than 37%
  • 20% if your ordinary income is taxed at 37%

To meet the requirements for a qualified dividend, the dividend must have been paid by a U.S. corporation or a qualified foreign corporation and meet the holding period, which is more than 60 days during a 121-day period, which starts 60 days prior to the ex-dividend date. The holding period is different for preferred stock.

Example

Company ABC declares 25-cent dividends per share. If an investor owns 10,000 shares of ABC Corporation common stock, the dividend payment received is $2,500. If the ex-dividend date is July 1, the investor needs to have owned the stock for more than 60 days from May 2 through Oct. 30, or the 121-day period, for the payout to be considered a qualified dividend.