Dividends are the payments companies make to their shareholders, and many of the best stocks of the past century have been companies that pay dividends. If you receive a dividend, you'll most likely have to pay taxes on it -- but how much you pay will depend on whether or not the payout is a qualified or a nonqualified dividend. 

The difference can be substantial. Depending on a few factors, many nonqualified dividends are taxed at your marginal tax rate, which, based on your earnings, could be as much as 39.5%. A qualified dividend is a dividend that meets a series of criteria that result in it being taxed at the lower long-term capital gains tax rate, or for some investors, not taxed at all. 

Needless to say, the potential tax-saving implications can be enormous. All things being equal, a qualified dividend may result in significantly more money remaining in your pocket than a similar nonqualified dividend. Keep reading to learn more about this critically important topic every dividend investor should understand. 

Businessman handing over money

Image source: Getty Images.

How to know if it's a qualified dividend

For a dividend to be considered qualified, it must meet certain requirements. This includes some criteria the company itself must meet, but also minimum holding requirements that you, the investor, must meet for a dividend to be considered qualified:

  1. It was paid either by a U.S. corporation or by a qualified foreign corporation (foreign corporations qualify if they are incorporated in a U.S. possession, are located in a nation covered by an income tax treaty with the U.S., or their stock is readily tradable in the U.S. securities market).

  2. It was an ordinary dividend, not capital gains distributions, dividends from tax-exempt organizations, and payments in lieu of dividends. Ordinary dividends are shown in box 1a of the Form 1099-DIV tax document each company sends out. 

  3. You've held the underlying stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date.

In summary, a qualified dividend is always a regular dividend, but a regular dividend isn't always a qualified dividend. Why does this matter? Because, in short, there are a number of dividends and distributions that are not regular dividends that may have different tax implications. 

Why qualified dividends can be advantageous 

In a word, taxes. The primary benefit of qualified dividends is that they "qualify" to be taxed at the same rate as the long-term capital gains rate, whereas unqualified ordinary dividends are taxed at the higher ordinary income tax rate, often referred to as your marginal tax rate

The difference in these rates can be substantial. Here is a rough breakdown of the difference in the tax rate you'll pay for qualified dividends versus unqualified regular dividends:

  • If you are in the 15% or lower tax bracket, you pay 0% tax on qualified dividends.
  • If your tax bracket is above 15% but below the top 39.6% tax bracket, you pay 15% on qualified dividends.
  • If you are in the top 39.6% tax bracket, you pay 20% on qualified dividends. 

The rates for long-term capital gains and qualified dividends is based which tax bracket your earnings -- not just dividends but all sources of taxable income -- place you in. 

For example, let's say that you're in the 28% income tax bracket, and you received $2,000 in dividends this year. If these dividends were qualified dividends, you'd pay taxes at a rate of 15%, which would come to $300. However, if these were nonqualified ordinary dividends, you'd pay taxes on them at a 28% rate -- producing a tax bill of $560. In short, owning stocks that pay qualified dividends could cut your taxes on those dividends almost in half.

The 0%, 15%, and 20% tax rates may look familiar to some investors. They should, because they're the long-term capital gains rates. These tax rates are what investors pay on gains for any stock investment they've held for at least one year. For qualified dividends, you gain that same highly advantageous tax rate. 

Taking advantage of the rules to do what already works best

Earning dividend income is an excellent way to build long-term wealth. It rewards the patient investor, who's willing and able to buy great companies, then keep holding them while getting paid as those businesses get bigger and stronger, and hopefully grow those dividend payments along the way. Simply put, buying great businesses and then sitting on your hands works great for dividend investing. 

Smart tax planning should play a big role in how you optimize your results. That includes taking advantage of tax-deferred accounts like an IRA, or tax-free accounts like a Roth IRA that can help you avoid almost all taxes, even on most dividend income. 

But when you're investing in a taxable account, the tax man cometh every year. So hedging your dividend stock portfolio toward stocks that pay a qualified dividend can make a big difference in how much wealth you can build -- and retain -- before you're ready to start enjoying the fruits of your investing labors.