What Are Qualified Dividends?

By: , Contributor

Published on: Nov 21, 2019

Certain stock dividends get favorable tax treatment -- here's what you need to know.

Stock dividends are generally taxed at lower rates than income you get from a job. But as you might expect, it's a bit more complex than that.

The IRS divides stock dividends into two main categories -- qualified dividends and ordinary dividends. Qualified dividends get favorable tax treatment, while ordinary dividends are taxed like ordinary income.

With that in mind, here's what a qualified dividend is and what it means for your tax bill.

What is a qualified dividend?

The IRS has two main requirements for a dividend to be "qualified":

First, the dividend must have been paid by a United States corporation or by a qualifying foreign entity. Typically, if a stock is readily tradeable on a U.S. stock market or is incorporated in a U.S. territory or possession, it meets this requirement.

You must have owned the stock for a minimum holding period. For common stocks, you must own the stock for at least 60 days during the 121-day window that extends 60 days before and after the ex-dividend date. For preferred stock dividends to be qualified, you must own the shares for at least 90 days during the 181-day window starting 90 days before the ex-dividend date.

Some types of dividends never meet the definition of qualified dividends, even if they meet the two requirements above. These include the following:

  • Dividends paid by tax-exempt organizations. This includes pass-through businesses that are exempt from corporate taxation. 
  • Distributions of capital gains. Long-term capital gains are taxed at the same rates as qualified dividends, but are categorized differently.
  • Dividends paid by credit unions on deposits, or any other "dividend" paid by a bank on a deposit.
  • Dividends paid by a company on shares held in an employee stock ownership plan, or ESOP.

Qualified dividend tax treatment

If your dividend income is qualified, it gets the same favorable tax treatment as long-term capital gains. These are taxed at 0%, 15%, or 20%, depending on your income, and are typically lower than the rates you pay on ordinary income. Here's a chart of the qualified dividend tax rates in the United States for the 2019 tax year:

Qualified Dividend Tax Rate Single Filers (Taxable Income) Married Filing Jointly Heads of Household Married Filing Separately
0% $0 to $39,375 $0 to $78,750 $0 to $52,750 $0 to $39,375
15% $39,376 to $434,550 $78,751 to $488,850 $0 to $461,700 $39,376 to $244,425
20% Over $434,550 Over $488,850 Over $461,700 Over $244,425

Data source: Tax Foundation.

It's also worth pointing out that you don't have to figure out which of your dividends are qualified. When your broker sends your year-end tax documents, it'll be broken down for you.

Ordinary dividends are taxed at higher rates

If your dividend income doesn't meet the definition of qualified dividends, it's taxed as ordinary income at your marginal tax rate (tax bracket). These are generally higher than the corresponding qualified dividend tax rates. You can find yours in the chart below.

Keep in mind that these figures are taxable income, meaning your income after all of your deductions have been considered.

Marginal Tax Rate Single Filers (Taxable Income) Married Filing Jointly Head of Household Married Filing Separately
10% $0 to $9,700 $0 to $19,400 $0 to $13,850 $0 to $9,700
12% $9,701 to $39,475 $19,401 to $78,950 $13,851 to $52,850 $9,701 to $39,475
22% $39,476 to $84,200 $78,951 to $168,400 $52,851 to $84,200 $39,476 to $84,200
24% $84,201 to $160,725 $168,401 to $321,450 $84,201 to $160,700 $84,201 to $160,725
32% $160,726 to $204,100 $321,451 to $408,200 $160,701 to $204,100 $160,726 to $204,100
35% $204,101 to $510,300 $408,201 to $612,350 $204,101 to $510,300 $204,101 to $306,175
37% Over $510,300 Over $612,350 Over $510,300 Over $306,175

Data Source: IRS. You can learn more about the U.S. tax brackets at Fool.com.

Both types of dividends may be subject to the net investment income tax

While qualified dividends are taxed at lower rates than ordinary dividends, it's important to point out that higher earners pay an investment income tax that's the same for all dividend income.

Specifically, the net investment income tax (NIIT) is a 3.8% tax rate applied to certain dividend income, interest income, capital gains, and other investment-derived income. If you're a single tax filer and have adjusted gross income (AGI) of more than $200,000 or file a joint return with AGI over $250,000, you have to pay the tax on any investment income that pushes your income over these limits.

Without getting too deep into a discussion of the NIIT, the point is that if it applies to you, the rate is the same whether your dividends are qualified or not.

An example of how qualified dividends save you money

Here's a simplified example of how this works. Let's say you're single and have taxable income of $100,000 in 2019 from your job. You also earn $3,000 in dividend income for the year. Based on your income, you would pay a 15% tax rate on qualified dividends or a 24% tax rate on ordinary dividends.

If your $3,000 in dividend income meets the criteria for qualified dividends, it would add $450 to your tax bill for the year. If it doesn't, it would add $720. In this case, the favorable treatment given to qualified dividends would save you $270 over your ordinary income tax rate.

REIT dividends can be a combination

Some dividends -- specifically those paid by real estate investment trusts, or REITs -- aren't just one type or the other.

In fact, REIT dividends are often made of three components. Most REIT distributions are ordinary dividends, but some might be qualified dividends or a non-taxable return of capital.

For example, leading net-lease REIT Realty Income (NYSE: O) paid $2.63 per share in common stock dividends in 2018. Of this, about 77% was ordinary income and the other 23% was a non-taxable return of capital. While the percentages can vary, this is a pretty typical distribution -- most REIT dividends are typically ordinary income, with a return of capital being the second-largest type of distribution in most cases.

In some cases, a small portion of a REIT's dividend might be a qualified dividend -- this happens if a REIT sold an asset at a profit and distributes some of its long-term capital gains to investors.

Like I mentioned earlier, you won't have to figure this out on your own. Each REIT issues tax guidance shortly after the end of the year. Your dividends should be broken down by category when your broker sends your annual tax paperwork.

These rules only apply to taxable accounts

The qualified dividend definition is only important if your dividends were paid in a taxable brokerage account.

If you own the stocks through an individual retirement account, or IRA, you won't have to pay any tax on dividend income you receive, regardless of whether the dividends are qualified or not. With a traditional (pre-tax) IRA, you won't owe any tax until you withdraw the money from the account. Even then, all of the money you withdraw will be treated equally as ordinary income. And with a Roth IRA, withdrawals that meet the IRS's requirements will be completely tax-free.

If all of this sounds very complicated, don't worry. It's good to know, but there's little chance that you'll have to figure it out yourself. Your broker or REIT will let you know whether your dividends are qualified.

Matthew Frankel, CFP owns shares of Realty Income. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.