Dividends are the payments companies make to their shareholders. If you receive a dividend, you'll have to pay taxes on it -- but how much you pay will depend on whether or not the dividend is a qualified one. Choosing stocks that pay qualified dividends can significantly reduce your tax bills -- and the bigger your dividends are, the more you'll save.
Qualified versus nonqualified dividends
A dividend is qualified if it meets certain requirements, namely:
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).
It was an ordinary dividend and not one of the oddball types such as capital gain distributions, dividends from tax-exempt organizations, and payments in lieu of dividends.
You've held the underlying stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date.
Taxes for qualified versus nonqualified dividends
The big benefit of qualified dividends is that they are taxed at the same rate as the long-term capital gains rate, whereas nonqualified dividends are taxed at the higher ordinary income tax rate. The rates for long-term capital gains and qualified dividends is based on your tax bracket. If your income puts you in a bracket that's higher than 15% but lower than 39.6%, then your tax rate is 15%. If you're in the 39.6% bracket, then your rate for qualified dividends is 20%; and if your top tax bracket is 15% or below, you enjoy a 0% rate, which means you won't pay taxes on qualified dividends at all.
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 dividends, you'd pay taxes on them at a 28% rate -- producing a tax bill of $560. In short, restricting yourself to qualified dividends could cut your taxes on those dividends almost in half.
Reporting your dividends
If you received $10 or more in dividends this year, your broker will send you a Form 1099-DIV early in the next year that will spell out exactly how much your dividends were and what type they were. Line 1a of the 1099-DIV will list the total amount of ordinary dividends you received, and line 1b will tell you how much of the total from line 1a came from qualified dividends.
You'll need to report all dividends you received, whether qualified or not, on your tax return for the year. Ordinary dividends go on line 9a of your Form 1040, and if you received more than $1,500 in ordinary dividends you'll also need to fill out Schedule B. Qualified dividends go on line 9b of the Form 1040. If you have any dividends to report, you won't be able to use Form 1040EZ, but you may still be able to use the Form 1040A.
It's crucial to report any dividends you received to the IRS, because your broker will have sent a copy of the Form 1099-DIV to them as well. That means leaving those dividends off your tax return will likely result in the IRS computers flagging you as a potential audit target. So do the right thing, pay the taxes on your dividends, and you'll save yourself a lot of hassle and misery later on.