When you receive a dividend payment from an investment, it will fall into one of two categories for tax purposes: qualified or ordinary. The tax rate on these two dividend classifications varies. Qualified dividends are the better of the two, as they have lower tax rates -- but not all dividends are eligible. You might be wondering, what are qualified dividends? Well, qualified dividends are listed in box 1b of the IRS Form 1099-DIV you receive, and they must meet the following two main criteria:

  • Must be issued by a U.S. corporation, or by a foreign corporation that readily trades on a major U.S. exchange, or by a corporation incorporated in a U.S. possession.
  • The shares must have been owned by you for more than 60 days of the "holding period" -- which is defined as the 121-day period that begins 60 days before the ex-dividend date, or the day on which the stock trades without the dividend priced in.

For example, if a stock's ex-dividend date is Oct. 1, then the shares must be held for more than 60 days in the period between Aug. 2 and Nov. 30 of that year in order to count as a qualified dividend.

And some types of dividends are automatically excluded from being qualified dividends, even if they meet the other requirements. These include (but are not limited to)

  • Capital gains distributions
  • Dividends on bank deposits
  • Dividends held by a corporation in an Employee Stock Ownership Plan (ESOP)
  • Dividends paid by tax-exempt corporations

Tax implications

The difference between qualified and ordinary dividends is quite substantial when the time comes to pay taxes. As the name implies, ordinary dividends are taxed as ordinary income, while qualified dividends are taxed at a lower rate.

Ordinary income tax rate

Qualified dividend tax rate

10%

0%

15%

0%

25%

15%

28%

15%

33%

15%

35%

15%

39.6%

20%

Note: There is an additional 3.8% Net Investment Income Tax (NIIT) for investors whose modified adjusted gross income exceeds $200,000 ($250,000 for married taxpayers filing jointly).

For more on dividend tax rates, check out this article.

The beauty of qualified dividends

Consider an example of an investor in the 28% tax bracket who owns $500,000 worth of dividend stocks, with an average yield of 4% per year. This investor receives $20,000 in annual income from dividends.

If those dividends were counted as ordinary income, this investor would get hit with a $5,600 tax bill, dropping the dividend income to $14,400. However, if these dividends met the definition of "qualified," the tax bill would be reduced to $3,000. In other words, the special rules for qualified dividends mean an extra $2,600 in this investor's pocket.

More importantly for long-term investors, this means that more of your dividend income stays in your portfolio to generate more gains in the future.

Now that you understand the tax implications of dividend income, head over to our broker comparison tool to learn more about investment accounts.

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