Qualified Dividends vs. Ordinary Dividends
Dividends are payments made by corporations to their shareholders, usually as a distribution of profits. In the U.S., the tax treatment of these dividends can vary based on their classification. Here’s a breakdown of qualified dividends versus ordinary dividends:
- Qualified Dividends:
- Definition: Qualified dividends are those dividends that meet specific criteria set by the IRS and thus qualify for a lower tax rate (akin to long-term capital gains rates) than ordinary income.
- Taxation: They are taxed at long-term capital gains rates, which tend to be lower than ordinary income tax rates. As of my last update in 2021, these rates are 0%, 15%, or 20%, based on the taxpayer’s taxable income and filing status.
- Requirements: For a dividend to be qualified, it must be:
- Paid by a U.S. corporation, or a qualified foreign corporation.
- Held for a specified period, typically more than 60 days during the 121-day period that starts 60 days before the ex-dividend date.
- Not on the IRS’s list of dividends that cannot be treated as qualified, such as dividends from tax-exempt organizations or dividends from certain foreign corporations.
- Ordinary Dividends:
- Definition: Ordinary dividends are those dividends that do not meet the criteria to be classified as qualified dividends.
- Taxation: They are taxed at the taxpayer’s regular income tax rate.
- Source: Most dividends that are received from a stock will be classified as ordinary unless they meet the criteria for qualified status.
It’s worth noting that not all distributions from corporations to shareholders are dividends. Return of capital distributions and capital gains distributions, for instance, are not classified as dividends and have their own unique tax treatment.
For the most accurate and current tax information, always consult the IRS’s official documentation or consult with a tax professional.
Example of Qualified Dividends vs. Ordinary Dividends
Let’s break it down with a hypothetical example to illustrate the difference between qualified and ordinary dividends in terms of taxation.
Scenario: Imagine you are a single taxpayer with a taxable income of $60,000 for the year, and you receive two dividends from different stocks you own:
- A $1,000 dividend from Company A, which is a qualified dividend.
- A $1,000 dividend from Company B, which is an ordinary dividend.
Let’s look at how each dividend would be taxed based on the tax rates as of my last update in 2021:
- Qualified Dividend from Company A:
- Given the taxpayer’s taxable income of $60,000 (and assuming they are not subject to any additional taxes such as the Net Investment Income Tax), their long-term capital gains rate would be 15%.
- Tax owed on this dividend: $1,000 * 15% = $150
- Ordinary Dividend from Company B:
- The ordinary income tax rate for a single taxpayer with a taxable income of $60,000 falls in the 22% bracket for 2021.
- Tax owed on this dividend: $1,000 * 22% = $220
For the year, this taxpayer would owe:
- $150 in taxes on the qualified dividend.
- $220 in taxes on the ordinary dividend.
Thus, the total tax on all dividends would be $370.
The key takeaway here is the difference in tax treatment between the two types of dividends. While the same amount was received from both companies ($1,000 each), the qualified dividend resulted in a tax savings of $70 compared to the ordinary dividend.
Remember, the tax brackets and rates can change, and individual circumstances (like other deductions, credits, or additional sources of income) can affect the exact tax outcome. This example is meant to illustrate the concept, and actual tax calculations can be more complex.