When tax time rolls around, it's important to understand if your dividend income is qualified or nonqualified. Qualified dividends are generally taxed at the capital-gains rate, significantly lower than the ordinary income-tax rate. Nonqualified dividends receive no such advantage, and are taxed at the ordinary tax rate.
First, what constitutes a qualified dividend?
According to the IRS, qualified dividends are dividends paid by domestic corporations and qualified foreign corporations. However, as with all things tax related, there's really a lot more nuance to it than that.
In general, though, regular dividends paid by corporations will be qualified, as long as certain holding requirements are met. For example, a common-stock dividend is considered qualified if the stock is owned for at least 60 days during the 120-day holding period that starts 60 days before the ex-dividend date.
For a preferred-stock dividend, the period is longer, with a 90-day requirement during the 180-day holding period. For buy-and-hold investors, though, these minimum holding periods will take care of themselves.
Some examples of nonqualified dividends may surprise you
For a typical stock with a routine dividend, the tax treatment will most likely be at the capital-gains rate as a qualified dividend. There are, however, numerous exceptions.
For example, special dividends are usually considered nonqualified, and taxed at the ordinary income-tax rate. Likewise, dividends paid by real estate investment trusts (REITS), and master limited partnerships (MLPs), are usually nonqualified.
The exceptions that drive nonqualified dividends don't stop there. Dividends paid on employee stock options, tax-exempt companies, and savings or money-market accounts are also typically nonqualified. Further, if you owned any puts, calls, or short sales associated with an otherwise qualified dividend, the IRS says that dividend is not considered nonqualified.
It's the exceptions, in this case, that make the rule.
Your accountant is your best friend when calculating the qualified and nonqualified portions of your dividend income
The reality for most investors is that the tax nuances and specificity required to accurately calculate the qualified and nonqualified portions of your dividends should be left to a professional accountant. For the most part, though, investing for the long term in a common stock that pays a regular dividend will be considered a qualified dividend, resulting in the favorable capital-gains tax rate on that income.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center, in general, or this page, in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!