As you've probably heard, recent tax law changes will allow some dividends to be taxed at a new, lower rate. However, not all dividends qualify, such as:
- Dividends on preferred stock if the stock is treated as a debt instrument
- Dividends from mutual funds attributable to interest and short-term capital gains (but "pass through" dividends from the mutual fund and long-term capital gain dividends do qualify)
- Dividends from tax-exempt organizations, including mutual savings banks and certain other savings institutions
- Dividends paid on money market accounts, patronage dividends, and policy dividends paid by insurance companies
- Dividends received in your IRA (either traditional or Roth) or other tax-deferred retirement account
- Distributions from S-Corporations (with a very limited exception)
- Dividends from real estate investment trusts (REITs) in general (again, with limited exceptions)
But even if you have a dividend that does qualify, you must meet the holding-period rules in order to benefit from the lower tax rates. There has been a bit of confusion as to these rules, so let's take a look at them.
Required holding period
For the dividend to be considered qualified, you are required to hold the underlying shares of stock for a certain period. This holding period revolves around the stock's ex-dividend date.
To qualify for the lower tax on the dividends, you're required to hold the stock for more than 60 days during the 120-day period beginning 60 days before the ex-dividend date. For preferred stock, the holding period is 90 days during the 180-day period beginning 90 days before the stock's ex-dividend date. The holding period includes the date of disposition, but not the acquisition date.
Essentially, what this means is that if you want to receive a dividend that qualifies for the lower tax rate, you must buy the stock as least one day before the ex-dividend date and hold that stock for at least 60 more days. Obviously, the holding period must include the ex-dividend date. But, curiously, the 61 days (91 days for preferred stock) don't have to be consecutive. And this holding period is true for all dividends, regardless if you receive them from stock, mutual funds, or any other investment that pays qualifying dividends. Still confused? Let's try an example.
Example: Consecutive holding period
Dee buys 100 shares of XYZ Corp. on Sept. 30, 2003, and continues to hold the stock through Dec. 31. XYZ Corp. declares a dividend. The record date is Oct. 15, 2003, and the ex-dividend date is established as Oct. 13, 2003. The dividend is payable on Nov. 1, 2003. Given these facts, the holding period must be satisfied somewhere between Aug. 13, 2003 (60-days before the ex-dividend date) and Dec. 12, 2003 (the end of the 120-day period).
In this example, Dee has received a qualified dividend. She purchased the shares before the ex-dividend date, and held the shares for the required 60-day period, which included the ex-dividend date.
However, if Dee would have sold the shares anytime before Nov. 29, 2003, her dividend would not be qualified since she didn't meet the 60-day holding period. Sure, Dee received the dividend before she sold the stock, so she has the dividend money in her pocket. But those dividends will not be subject to the lower dividend tax rates since she missed the required holding period.
Example: non-consecutive holding period
Let's use the same facts as above. And let's say that Dee does sell her 100 shares of XYZ Corp. on Nov. 10, 2003, making her dividend non-qualified and subject to higher taxes. Dee wasn't aware of the holding period rules until she read this article. So, upon seeing the error of her ways, she immediately buys another 100 shares of XYZ Corp. on Nov. 20, 2003, and holds those shares until Feb. 15, 2004.
Dee has miraculously turned her non-qualified dividends into qualified dividends subject to the lower tax rates. How? Remember that the holding period does not have to be consecutive. When you combine the total of Dee's holding periods, you find that she held the shares for the required 61 days within the 120-day period.
It'll be more important than ever to make sure that your dividends are qualified and subject to the new, lower tax rates. Nobody will tell you if they're qualified or not: That determination is your responsibility. The company will certainly send you a Form 1099DIV, which tells you (and the IRS) that you received a dividend payment. But that dividend payment won't be qualified unless you meet your holding-period requirements.
Generally, if you hold your shares for at least 61 consecutive days, one of which is the ex-dividend date, you will satisfy the holding period rules. But if you're an active trader of a dividend-paying stock, or are involved in more sophisticated transactions (such as selling short), you'll have to look closely to determine if your dividends are qualified. If you are a trader in dividend-paying stocks, check out Ex-Dividend.com for essential information on dividends and important related dates. NYSE dividend information requires a subscription, but Nasdaq and AMEX information is free.
Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.