Are dividends considered passive or ordinary income?
Despite the fact that earning dividends requires no active participation on the part of the shareholder, they do not meet the criteria for passive income as outlined by the Internal Revenue Service (IRS). However, depending on how long you have owned your stock, your dividends may be considered qualified and could be taxed as capital gains rather than ordinary income.
What Are Dividends?
Dividends are a way for publicly-traded companies to redistribute profits to shareholders as a reward for their investment. Though dividend payment is not mandatory, many companies choose to issue dividends each year to illustrate their profitability and encourage additional investment. Dividends are paid either in cash or additional shares of stock.
Passive income, as defined by the IRS, can only be generated by rental activity or by a business in which you have a financial interest but do not play an active role. If you own a home that you rent out, any income that your renters pay to you is considered passive income, including any fees you may charge. Outside of your role as a landlord, the only other way to create passive income is to bankroll a business that you do not actively participate in, commonly called being a silent partner.
Because dividends do not fall into one of these two categories, they are considered ordinary income.
Though most dividends paid by corporations or mutual funds 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.
Qualified dividends 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 December 1, for example, then you must have owned the stock for at least 60 days during the period between June 3 and October 2.
To learn more, read: 3 Tax Implications of Dividend Stocks.
One might get the impression that dividends are passive income because owning a stock and receiving dividends is passive in nature. Often times, portfolio income, interest, and even lottery winnings will be confused as being passive income by investors. There are only two sources of passive activity: rental activity income or business income in which the taxpayer does not materially participate.
Dividends can be classified as either ordinary or qualified. Ordinary dividends are taxable as ordinary income, qualified dividends that meet certain requirements are taxed at lower capital gain rates. Ordinary dividends are the most common type of distribution you would receive from a corporation or a mutual fund. You can assume that any dividend you receive is an ordinary dividend unless the delivering firm tells you otherwise.
For a dividend to be considered qualified; the dividend must be paid by a US corporation or a qualified foreign corporation and you must meet a specific holding period. For the holding period to qualify you must hold the stock that is paying the dividend for 60 days during the 121-day period that begins 60 days before the ex-dividend date. There is also a list of distinct types of dividends that are automatically considered non-qualified. Some popular examples on this list are dividends paid by:
- Real estate investments trusts (REITs)
- Master limited partnerships (MLPs)
- Employee stock options
- Tax-exempt companies
I hope you found this helpful.
I am sure you are asking about dividends from investments. Don't forget that some life insurance policies also pay dividends. See below.
To tell you the truth, I think the question regarding these is whether not they are passive income or portfolio income. I'm going to guess portfolio income, but you should check with your accountant.
"If you have a cash value life insurance policy that pays dividends, you may be liable to pay taxes on the amount of dividends that exceed the amount of the premiums paid for the policy. Otherwise, policy dividends are generally not taxable. Again, you will receive a Form 1099-DIV by Jan. 31 citing the amount of dividends paid that must be included in your taxable income." http://www.foxbusiness.com/features/2013/05/23/taxability-life-insurance.html