What Are Qualified Dividends, and How Are They Taxed?

What Is a Qualified Dividend?

Ordinary dividends are payments a public company makes to owners of its common stock shares. It is their share of the company's profits and a reward for holding onto the shares. A qualified dividend is an ordinary dividend that can be reported to the IRS as a capital gain rather than income.

For some but not all taxpayers, that is a significant saving in taxes owed on the dividends. Individuals earning over $41,675 ($83,350 if married and filing jointly) pay at least a 15% tax on capital gains as of the 2023 tax year. If you earn less than that, you don't pay taxes on capital gains—you only pay income taxes.

Understanding Qualified Dividends

Dividends are separated into two classes by the IRS, ordinary and qualified. A dividend is considered to be qualified if you have held a stock for more than 60 days in the 121-day period that began 60 days before the ex-dividend date. It is an ordinary dividend if you purchase it after the ex-dividend date.

The ex-dividend date is one market day before the dividend's record date. The record date is the date at which a shareholder must be on the company's books to receive the dividend.

For example, imagine you owned XYZ stock, which declared a dividend payment on Nov. 21 and set a date of record for a month later, Dec. 19. If you bought XYZ stock less than 60 days before Dec. 19 and received a dividend, it will be counted as ordinary income on your tax return for that year.

If you bought XYZ stock more than 60 days before the record date and held it for at least 61 days in the 121 days before the next dividend, you'd pay the capital gains tax rate on the dividend.

Capital gains are currently taxed at a rate of 0%, 15%, or 20%, depending on the taxpayer's income. If you have capital gains from selling collectibles or a qualified small business stock, you might pay up to 28%. Unrecaptured gains from selling section 1250 real property is taxed at up to 25%. So, most investors pay zero or 15%, with only the highest earners paying the 20% rate.

There are several other requirements for qualified dividends:

• The dividend must have been paid by a U.S. company or a qualifying foreign company.
• The dividends are not listed with the IRS as those that do not qualify.
• The required dividend holding period has been met.

Where to Find Qualified Dividends

IRS Form 1099-DIV, Box 1a, Ordinary Dividends sent from your broker shows all your dividends. Qualified dividends are listed in Box 1b on form 1099-DIV and are the portion of ordinary dividends from Box 1a that meet the criteria to be treated as qualified dividends.

Qualified Dividend Tax Treatment

Qualified and ordinary dividends have different tax implications that impact your net return. The tax rate is 0% on qualified dividends if your taxable income is less than $41,675 for singles and $83,350 for joint married filers.

If you make more than $41,675 (single) or $83,350 (joint), you'll have a 15% tax rate on qualified dividends. If your income exceeds this, your capital gains tax will be 15%—at least to the upper threshold of the bracket.

Note that there is an additional 3.8% Net Investment Income Tax (NIIT) on investment gains or income. The IRS uses the lowest figure of your net investment income or the excess of your modified adjusted gross income (MAGI) that exceeds $200,000 for single filers, $250,000 for married filing jointly, and $125,000 for married filing separately to determine this tax.

So, to incur the NIIT, your MAGI must exceed the previously listed thresholds.

Other Qualifying Dividend Requirements

Foreign Companies

A foreign corporation qualifies for the special tax treatment if it meets one of the following three conditions: the company is incorporated in a U.S. possession, the corporation is eligible for the benefits of a comprehensive income tax treaty with the United States, or the stock is readily tradable on an established securities market in the United States. A foreign corporation is not qualified if it is considered a passive foreign investment company.

Dividends That Do Not Qualify

Some dividends are automatically exempt from consideration as qualified dividends. These include dividends paid by real estate investment trusts (REITs), master limited partnerships (MLPs), employee stock options, and those on tax-exempt companies.

In addition, dividends paid from money market accounts, such as deposits in savings banks, credit unions, or other financial institutions, do not qualify and should be reported as interest income.

Special one-time dividends are also unqualified.

Finally, qualified dividends must come from shares not associated with hedging, such as those used for short sales, puts, and call options. These investments and distributions are subject to the ordinary income tax rate.

Holding Periods for Other Investments

Preferred stocks have a different holding period than common stocks. You have to hold preferred stock for more than 90 days during a 181-day period that starts 90 days before the ex-dividend date.

The holding period requirements are somewhat different for mutual funds. The mutual fund itself must have held the security unhedged for at least 60 days of the 121-day period, which began at least 60 days before the security's ex-dividend date. To receive capital gains tax treatment in your mutual fund, you must have held the applicable share of the mutual fund for the same period.

What It Means for Investors

Most regular dividends from U.S. corporations are considered qualified. The question of whether you have qualified dividends or not can arise if you focus on foreign companies, REITs, MLPs, or tax-exempt companies.

If you don't stray from the big names in common stocks, you need only be careful to hold onto the shares long enough to qualify for the dividend payments.

The Bottom Line

For most individual investors, qualified dividends offer the chance of a tax break. The ordinary dividends of most American companies are, in fact, qualified dividends. The investor's only concern should be to qualify for the dividend by purchasing shares more than 60 days before the ex-dividend date and holding it until the dividend is paid.