How Are Qualified Dividends Taxed?

Qualified dividends are taxed at lower rates than ordinary dividends, making them appealing for investors. These earnings are taxed at capital gains rates. To be eligible for lower rates, dividends must come from U.S. corporations or qualified foreign companies, and the investor must meet the holding period requirement. Understanding these tax distinctions around qualified dividends can help investors make informed decisions when managing their portfolios.

A financial advisor can recommend strategies to maximize after-tax income and ensure that qualified dividends are taxed at the lower rate.

What Is a Qualified Dividend?

Qualified dividends are payments made by corporations to shareholders who meet specific criteria, allowing them to be treated more favorably for tax purposes.

For dividends to be classified as qualified, they must be paid by a U.S. corporation or a qualifying foreign corporation. Foreign corporations may be eligible if they are based in a country with a tax treaty with the United States or if they meet certain other U.S. tax law criteria. Most dividends from well-known, publicly traded U.S. companies will meet these qualifications.

Additionally, a qualified dividend must meet specific holding period requirements, where investors need to hold the stock for a minimum length of time. These rules are in place to ensure that investors hold onto their stocks for a minimum duration before benefiting from favorable tax treatment. Here’s a breakdown of the key holding period requirements:

• Minimum holding period for common stocks: You must hold the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. The ex-dividend date is the day after the cutoff for receiving the dividend. If you purchase the stock on or after this date, you are not entitled to that next dividend payment.

• Minimum holding period for preferred shares: For certain preferred stocks, a longer holding period may apply. You must hold the stock for more than 90 days during a 181-day period starting 90 days before the ex-dividend date, particularly if the dividend is related to a period of more than 366 days.

Note that the 60-day holding period does not have to be continuous, but the total must add up to at least 60 days within the 121-day window. If the stock is borrowed or hedged during the holding period, the days may not count toward the holding requirement, potentially disqualifying the dividend from receiving qualified treatment.

While many dividends meet the requirements for qualified tax treatment, some dividends cannot qualify, even if they come from a U.S. corporation. For example, dividends from certain types of tax-advantaged accounts, such as tax-exempt organizations, do not qualify. Similarly, if you hedge your stock position with certain financial tools like options or short sales, dividends earned on those positions may not be treated as qualified.

How Qualified Dividends Are Taxed

Qualified dividends enjoy favorable tax treatment, offering lower tax rates compared to other forms of investment income. As of 2024, qualified dividends are taxed at long-term capital gains rates, which vary depending on your taxable income, as seen in the table below:

Example of Qualified Dividends Taxation

Consider a high-income earner in the 35% tax bracket. They invest in dividend-paying stocks from a U.S. corporation, which issue qualified dividends. Over the course of the year, the investor receives $10,000 in qualified dividends. Because these dividends meet the holding period and entity requirements, they are taxed at the long-term capital gains rate of 15%, rather than at the investor’s ordinary income tax rate of 35%.

Had these dividends not been qualified, the investor would have paid $3,500 in taxes, but because they are qualified, they only owe $1,500. This results in a $2,000 tax savings, significantly boosting their after-tax returns.

By strategically holding these dividend-paying assets in their portfolio, the investor enjoys regular income at a lower tax rate, allowing him to compound his wealth more efficiently over time, particularly with a long-term investment horizon.

Tax Implications of Qualified Dividends vs. Ordinary Dividends

The key difference between qualified vs. non-qualified dividends lies in their tax treatment.

Ordinary dividends, also known as non-qualified dividends, are paid by corporations but don’t meet the eligibility requirements for qualified status. These could include dividends from certain types of investments, like real estate investment trusts (REITs) or master limited partnerships (MLPs). Ordinary dividends are taxed at the same rate as your regular income, which can range from 10% to 37%, depending on your tax bracket.

In contrast, qualified dividends benefit from lower tax rates because they come from companies that meet stricter criteria and reward long-term investment. Capital gains tax rates apply, which are 0%, 15% or 20%, depending on your taxable income.

Bottom Line

Qualified dividends offer a tax-efficient way for investors to generate income from their portfolios. By understanding the specific requirements, such as ensuring the dividends come from eligible corporations and meeting the holding period, investors can benefit from significantly lower tax rates compared to other forms of income. These lower rates provide an opportunity to maximize after-tax returns, especially for those in higher tax brackets. For long-term investors, qualified dividends can play a key role in building wealth, as the reduced tax burden allows more of the investment gains to stay within the portfolio, compounding over time.

Investment Planning Tips

• A financial advisor can help optimize your finances to lower your tax liability. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

• If you want to know how much an investor could grow over time, SmartAsset’s investment calculator could help you get an estimate.

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