What Are Ordinary Dividends?
Ordinary dividends are a share of a company's profits passed on to the shareholders periodically. One of the primary advantages of owning stocks, also known as equities, is the regular payment of dividend income.
Dividends are considered "ordinary" by default, although there are cases when a dividend may be classified as "qualified" because it meets specific criteria. Ordinary dividends are taxed as ordinary income, while qualified dividends are taxed at the lower capital gains rate.
- Ordinary, or non-qualified, dividends are paid by corporations to shareholders of record.
- Dividends are considered ordinary by default unless they meet special requirements put in place by the IRS.
- Ordinary dividends are taxed as ordinary income, while qualified dividends are taxed at the lower capital gains rate.
What Is A Dividend?
Understanding Ordinary Dividends
Dividends earnings fall into two general categories: qualified or nonqualified (ordinary) dividends. Much of the distinction comes from the company paying the earnings and how the Internal Revenue Service (IRS) views the payments.
Unless a dividend payment is classified as a qualified dividend payment, it is taxed as ordinary income. To classify as a qualified dividend instead of an ordinary one, the earnings must come from an American company—or a qualifying foreign company—and it must not be listed as an unqualified dividend with the IRS. Also, it must meet a required holding period. Holding periods are:
- At least 60 days for a common stock
- 90 days for a preferred stock
- 60 days for a dividend-paying mutual fund
Ordinary dividends may include a range of other dividends or other earnings you may receive throughout the year. These earnings include those paid on real estate investment trusts (REIT). The primary difference between ordinary dividends and qualified dividends is the tax rate.
The tax rate you pay on ordinary dividend earnings is at the same level as taxes for regular federal income or wages. Companies that pay these earnings to stockholders on record report all aggregate ordinary dividends in box 1a of Form 1099-DIV. Mutual fund companies pay and report these dividend payments in the same manner. For tax filings, you will list these earnings on Internal Revenue Service (IRS) Form 1040, Schedule B, Line 5.
Tax Changes on Dividends
The main differences between ordinary dividends and qualified dividends are the rates at which the gains are taxed. Through the years, these tax rates have changed through several acts of Congress.
In 2003, all American taxpayers received a reduction in their income tax rates. The qualified dividend tax rate was also changed from the ordinary income tax rates to lower long-term capital gains tax rates. The legislation that made it possible was called the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). This bill also reduced the maximum long-term capital gains tax rate from 20% to 15% and established a 5% long-term capital gains tax rate for taxpayers in the 10% and 15% ordinary income tax brackets.
A couple of years later, the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) prevented several tax provisions of the 2003 bill from sunsetting, or ending, until 2010. Also, for low to middle-income taxpayers in the 10% and 15% ordinary income tax bracket, it lowered the tax rate again on qualified dividends and long-term capital gains from 5% to 0%.
The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 extended these earlier provisions for two additional years. Signed Jan. 2, 2013, the American Taxpayer Relief Act of 2012 made qualified dividends a permanent part of the tax code but added a 20% rate on income in a newly created tax bracket in 2013 (which became the highest tax bracket). All tax brackets may be adjusted for inflation every tax year by the IRS.
In 2021, the maximum tax rate for qualified dividends and ordinary dividends is 20% and 37%, respectively.
The 2017 Tax Cuts and Jobs Act put through by President Trump's administration had little impact on taxes on dividends and capital gains.
Example of Ordinary Dividends
As a hypothetical example, consider the fictitious Joe Investor. He has 100,000 shares of Company ABC stock, which pays a dividend of $0.20 per year. In total, Joe Investor receives 100,000 x $0.20 = $20,000 per year paid in dividends from Company ABC.
Because Company ABC does not pay qualified dividends, Joe Investor must pay the regular income tax rate on those dividends instead of the capital gains tax rate.