Savvy investors understand the importance of qualified dividends. It’s not a topic you hear about often, but qualified dividends can unlock tax advantages and optimize your returns from shareholder payouts.
Qualified dividends are a type of dividend that receives preferential tax treatment in the U.S. They are subject to lower tax rates than ordinary dividends.
The favorable tax treatment of qualified dividends aims to encourage long-term investment by rewarding shareholders who stick around long enough to participate in a company’s growth. Here’s what you need to know about qualified dividends:
- Ordinary vs. qualified dividends: What’s the difference?
- How are qualified dividends taxed?
- Criteria for qualified dividends.
- How to pay taxes on qualified dividends.
Ordinary vs. Qualified Dividends: What’s the Difference?
“You can think of qualified dividends as the VIPs of the dividend world,” says Taylor Kovar, CEO of Kovar Wealth Management in Lufkin, Texas. “You receive payments just like ordinary dividends, but they also come with a golden ticket: Lower tax rates.”
It’s not difficult to find companies whose dividends may qualify for this preferred tax treatment. The rates range from 0% to 20%, depending on income, compared with ordinary dividend tax rates of 10% to 37%.
“Many well-established companies that have a history of consistent earnings and meet specific criteria set by the Internal Revenue Service may pay qualified dividends,” says Seth Diener, client portfolio manager and team lead at Diener Money Management in Newtown, Pennsylvania.
“These companies often have a good track record of generating profits and distributing a portion of those profits to shareholders as dividends,” Diener says.
How are Qualified Dividends Taxed?
Instead of being taxed at ordinary income tax rates, qualified dividends are taxed at the lower long-term capital gains tax rates.
“When you receive qualified dividends, you luck out on taxes,” says Armine Alajian, founder of the Alajian Group, a Los Angeles-based accounting firm. “They’re generally taxed at lower rates compared to other types of income, like your salary or interest.”
Qualified dividends are taxed at long-term capital gains rates of 0%, 15% and 20% in 2023, explains Lei Han, associate professor of accounting at Niagara University in Niagara Falls, New York. For individual filers with taxable income of $44,625 or less, or joint filers with $89,250 or less, the tax rate is 0%. For individual filers with taxable income between $44,626 and $492,300, or joint filers between $89,251 and $553,850, the tax rate is 15%.
That rate goes up to 20% for individual filers with taxable income of $492,301 or more, or joint filers with $553,851 or more.
Higher earners, which include individuals with modified adjusted gross income of more than $200,000 for individuals or more than $250,000 for those filing jointly, are subject to an additional 3.8% net investment income tax.
Criteria for Qualified Dividends
Abby Joseph, founder and CEO of Serenity Financial Services in Atlanta, says qualified dividends amount to “a little bonus for being an investor.”
She adds that dividends must meet certain conditions to receive the special tax treatment. Those criteria, set by the Internal Revenue Service, include:
Holding period. You must hold a stock for a minimum period, typically more than 60 days out of a 121-day period that begins 60 days before the ex-dividend date. This requirement is necessary to prevent people from buying a stock just before the dividend record date solely to benefit from the lower tax rate. It’s designed to encourage long-term investment.
“It’s like a rewards program,” says Kovar. “Stay loyal and you reap the benefits.”
Type of stock. Qualified dividends are generally limited to those received from common and preferred shares of U.S. corporations and certain foreign corporations that meet specific criteria. Foreign companies whose dividends qualify include those incorporated in a U.S. possession, those with a comprehensive tax treaty with the U.S., or those listed on a U.S. exchange.
It’s important to note that not all dividends automatically qualify for preferential tax treatment. Dividends from real estate investment trusts, master limited partnerships and certain foreign corporations may not qualify and are subject to different tax rules.
Investors can end up with securities paying qualified dividends in a couple of situations, explains Alajian.
The first situation is when investing in well-established companies that distribute dividends to shareholders that meet the qualification requirements.
“Two, certain investment vehicles like real estate investment trusts or mutual funds may also pay qualified dividends if they meet the necessary criteria,” she says.
How to Pay Taxes on Qualified Dividends
To file the taxes due on your qualified dividends, you will receive Form 1099-DIV from the payer of the dividend. That form will indicate the total amount of qualified dividends you received during the tax year. You will then report this information on Schedule B of your Form 1040 when filing your taxes.
Joseph offers a reminder about staying vigilant about the tax treatment of qualified dividends.
“As tax laws can be complex and subject to change, it’s advisable to consult a tax professional or refer to the IRS guidelines to ensure accurate reporting and understanding of qualified dividends in your specific situation,” she says.
Copyright 2023 U.S. News & World Report