Qualified Dividends: Tax Benefits and Requirements

·6 min read
"Uncover the benefits"
"Uncover the benefits"

Earning dividends is a valuable source of income for investors, particularly those saving for retirement. The IRS allows qualified dividends to be taxed at a lower capital gains rate than the higher income tax rate. Here’s a breakdown of the tax requirements, the benefits, how they work and how they differ from ordinary dividends. Consider speaking with a financial advisor before you begin investing or become a shareholder.

What Is a Qualified Dividend?

A dividend is a way for a company or fund to distribute payments to their investors. These typically come in the form of cash and on a quarterly basis. However, it is also possible for a corporation to offer other assets, such as stocks, property or even services.

These earnings came into play with the 2003 tax cuts former president George W. Bush signed into law. In particular, the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) created them. Up until then, all dividends were taxed at the rate of the investor’s income bracket. With the JGTRRA, the taxes on qualified dividends were lowered. This encouraged entities to pay their investors rather than hold onto their cash.

How Qualified Dividends Work?

Dividends are rewards for corporate or mutual fund investors. So, you have to become a shareholder of a qualifying and domestically based company to earn them. If you are an investor, you will receive a dividend from the company whose shares you own. However, these dividends are designed for long-term stockholders.

For a dividend to become qualified, you must hold on to it for more than 60 days. That must take place over a 121-day period beginning 60 days out from the ex-dividend date. This date is the cutoff point for you to purchase a stock and receive a dividend from it. In contrast, if you hold dividends from a mutual fund, you have slightly different rules. You must hold the security unhedged for a minimum of 61 days out of the 121-day period.

While the process may sound confusing, most dividends are considered qualified from U.S. companies. Essentially, if you keep the stock for a few months, you’ll probably earn the qualified rate.

Qualified Dividends Requirements

There are some criteria that each dividend must meet to become qualified. The Internal Revenue Service (IRS) determines and outlines these rules. Meeting these requirements entitles you to lower taxes on your dividends.

  • The company or entity paying the dividend must be domestic or a qualified foreign corporation that trades on the NYSE stock exchange. These foreign companies have their own set of guidelines to qualify.

  • The distributions must be ordinary dividends. They cannot be capital gains distributions or come from tax-exempt entities.

  • They must meet the minimum necessary holding period. Common stocks and preferred stocks have different holding period lengths.

Certain investments do not pay you in qualified dividends. For example, real estate investment trusts (REITs) and master limited partnerships (MLPs) do not usually distribute qualified dividends to their investors.

Qualified Dividend Tax Benefits

CPA preparing taxes
CPA preparing taxes

Qualified dividends are taxed differently than normal dividends. The former is taxed at the capital gains rate. So, let’s look at the 2021 tax brackets for single and joint filers of qualified dividends. For single filers, you pay a 0% capital gains rate for up to $40,400. After that, you pay a 15% rate if you fall in a tax bracket between $40,401 and $445,850. Anything higher than that results in a 20% rate.

Joint filers see the same low rates. They pay a tax rate of 0% on dividend income up to $80,800, 15% on up to $501,600 and 20% for anything exceeding that.

Ordinary Dividends vs. Qualified Dividends

There are two forms of dividends: ordinary and qualified. Ordinary, or non-qualified, dividends are much more common than their counterpart. Just like qualified dividends, they are paid out from company or corporation’s earnings to its stock holders. These payments tend to come from sources outside of stocks, though. Examples of this include savings accounts, certificates of deposit and REITs. Reporting an ordinary dividend is a little different from a qualified dividend since it is not taxed in the same way.

You report any income from an ordinary dividend in box 1a on the 1099-DIV form, just like you would any income. So, it’s taxed like the wages you earn from your job. If you receive more than $1,500 in these ordinary dividends, though, you have to use another form called the Schedule B (Form 1040), Interest and Ordinary Dividends.

In comparison, qualified dividends are taxed as long-term capital gains instead of regular income. This taxation comes at lower rates. For example, look at the 2021 tax year brackets. Single filers and joint filers alike can pay from 10% to 37% on ordinary income, whereas the capital gains rate caps at 20%. Remember, your qualified dividends are also reported on the 1099-DIV form but in box 1b.

What Qualified Dividends Means to You?

If you’re not yet a shareholder, then a qualified dividend doesn’t mean much to you. However, if you are considering opening a portfolio or becoming an investor, it may incentivize you. A qualified dividend comes with favorable tax benefits that appeal to both the stockholder and the company distributing them.

You can continue to reduce your taxes on your qualified distributions. For example, you can offset your capital losses through tax-loss harvesting. Or, you can put your investments in a tax-deferred investment account, like an IRA or 401(k). Many people use these dividends to support their retirement income. You do not have to pay taxes on income held in a retirement account, which can help you avoid taxes on your dividends entirely. So, reinvesting may be a valuable option. However, it’s important to know how long a company may pay you dividends since it likely will not have a guaranteed term.

The Takeaway

"TAX" and a pair of scissors
"TAX" and a pair of scissors

Qualified dividends are a way to reward long-term shareholders. They are taxed at a lower rate than ordinary dividends, giving them a tax benefit status. You can increase your dividend income by putting it in a retirement account for when you’re retired. If you want to incorporate qualified dividends into your income, consider speaking with a financial advisor. They can help you create a plan that adjusts accordingly to your goals.

Tips for Building Retirement Savings

  • Saving for retirement is a vital step in every adult’s life, but getting started may be confusing. You have to decide your goal amount, what methods of saving you want to use and more. Finding the right financial advisor can help with this, and the right one is just around the corner. SmartAsset’s free match tool helps you find local advisors within minutes who fit your needs. If you’re ready to start on the path to a financially stable retirement, get started now.

  • You’ll need to create a budget that can accommodate both your retirement needs and wants. Consider the steps you may have to take to make your retirement savings last.

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