What are Qualified Dividends?

Dividends can be a passive way to boost your portfolio returns over time. When you invest in a company that pays part of its profits in dividends, you can sit back and watch your money grow.

Like most other income sources, you will likely pay tax on dividends you earn. But did you know you could save a substantial amount in taxes with qualified dividends? Read on to find out what are qualified dividends and how they work. 

How Do Qualified Dividends Work?

The payments a company makes to distribute its earnings to shareholders are known as dividends. Dividend payouts received are taxed as ordinary income. Depending on taxable income, ordinary dividend tax rates could be as high as 37%.

However, qualified dividends are taxed at capital gains rates when they meet a series of criteria. When taxed at capital gains tax rates, you can keep more money in your pocket with the tax savings.

Understanding Qualified Dividends

To be considered qualified, the dividend must meet specific requirements set by the Internal Revenue Service (IRS), including;

• A U.S. Corporation or qualified foreign corporation must pay the dividend.
• Dividends cannot be from entities that don’t meet IRS rules for qualified dividend income, such as regulated investment companies (RIC) and real estate investment trusts (REITs).
• The investor must hold the stock more than 60 days before the ex-dividend date for common stock or more than 90 days before the ex-dividend date for preferred stock.

Tax Implications

Investors can benefit from more favorable capital gains tax rates with qualified dividends. Depending on your taxable income, capital gains tax rates range from 0% to a maximum of 20% for qualified dividends. In contrast, investors pay ordinary income tax rates on non-qualified dividends, with marginal tax rates as high as 37%.

How to Determine Qualified Dividends

Investors should understand key dates to determine whether dividends are ordinary or qualified. These critical dates include:

• Record date: The shareholder must be in the company's books to receive a dividend on the record date.
• Ex-dividend date: One market day before the dividend’s record date.         
• Holding period: Dividends may be qualified when you hold the stock for more than 60 days in the 121-day holding period. The holding period starts 60 days before the ex-dividend date.

To illustrate, assume you bought 10 shares of ABC stock. The company declares a dividend on October 1 and sets the record date as November 1. If you purchased ABC shares at least 60 days before the November 1 record date, the dividends received pay tax at capital gain rates.

The dividends would count as ordinary income on your tax return if you purchased the ABC stock less than 60 days before the November 1 record date.

You can also identify qualified dividends from the IRS Form 1099-DIV. This report shows how much dividend income you received for the year. Box 1a of the 1099-DIV form reports the ordinary dividends you received during the year. Box 1b on Form 1099 states the share of regular dividends that meet the qualified dividend criteria. 

Benefits of Qualified Dividends

Qualified dividends offer a handful of benefits including lower tax rates, increased investment returns and other advantages to long-term investors.  

Lower Tax Rates

You'll pay capital gains tax rates on qualified dividends, which can be substantially lower than ordinary income rates. Your capital gains tax bracket may range from 0% to 20% based on your taxable income.

Assume a single taxpayer with an annual taxable income of $40,000 earns a $1,000 dividend payment in 2023. Single taxpayers with taxable income of $41,675 or less pay a 0% capital gain rate on qualified dividend payments. If the dividend payout meets the qualified dividend requirements, no tax capital gains tax is due from the taxpayer.

If the dividend is not qualified, a single taxpayer making $40,000 will pay an income tax rate of up to 12% on most of the payout. 

Potential for Increased Returns on Investments

Qualified dividends may help investment returns outpace inflation. If an investment offers a 3% price increase, but inflation grows at 4%, the investor incurs a 1% loss.

If the investment above realizes a 3% price increase and a 2% dividend yield, the investor earns a 1% profit after inflation. 

Advantages for Long-Term Investors

Qualified dividends can help build your investment portfolio over time. The less you pay in dividend tax, the more you have to reinvest. Reducing your taxes as a long-term investor can significantly impact the overall return of your investment as the money you reinvest compounds over the years.

Qualified dividends benefit investors living off the income earned from dividends. If you have a long-term outlook when you invest in stocks, your goal may be to generate a steady income stream, which you can use when you retire.

Qualified dividends may help investors who rely on a stream of dividend income keep more of their money. By claiming the lower capital gains tax rate, you pay fewer taxes. The capital gains rates are especially beneficial for investors in a higher ordinary income tax bracket.

Tips for Maximizing Qualified Dividends

You may be able to maximize qualified dividends when you hold the stock in a tax-advantaged account. When investors directly hold stock or keep shares within their brokerage account, they pay tax on the dividends earned. When you hold dividend stocks in tax-advantaged accounts, like an IRA or a 401(k), you defer paying tax on the growth and income generated. The more money you hold in your tax-advantaged account, the more it can grow.

You can also maximize qualified dividends through diversification. Strive to own a variety of dividend stocks from different companies and industries. By holding shares across multiple sectors, you can limit exposure to company or industry risk. Diversification lets you spread volatility risk associated with the stock market.

Using a dividend reinvestment plan (DRIP) can help maximize qualified dividend income. Through a DRIP plan, you automatically turn dividends earned into additional shares of stock. Reinvested dividends help grow your investment and may increase future dividend returns.

Qualified dividends can help investors keep more of their investment by paying lower taxes.

Grow your Portfolio with Qualified Dividends

Dividend stocks can be an effortless way for investors to grow wealth over time. The less tax paid on dividend income, the more money you keep. Whether you generate an income stream or reinvest what you have earned, qualified dividends offer a considerable advantage of lower tax rates.

Frequently Asked Questions