Dividend payments are made to stockholders as a share of a taxed entity’s property. They’re payments made by corporations, as well as businesses that are taxed as corporations including partnerships, real estate investment trusts (REITs), estates or associations.
They’re typically cash payments, although they can be additional shares of stock. They’re paid on a schedule, usually quarterly or every three months. There are two primary types of dividends: qualified and ordinary. They’re both taxable distributions if you receive them.
What Is a Qualified Dividend?
Unless dividend stocks are held in a tax-favored retirement account like an IRA, qualified dividends are subject to lower tax rates: 0 percent, 15 percent or 20 percent. They’re taxed the same as long-term capital gains distributions. However, the key term here is “qualified.” These dividends must meet certain criteria.
First, they must be paid to you by a U.S. corporation or a qualified foreign corporation. Yes, the foreign corporation must qualify, too. It must be incorporated in a United States possession, be eligible for a comprehensive income tax treaty with the U.S. or the stock must be available and tradable on an established U.S. securities market, according to the IRS.
Qualified dividends are also subject to a holding period. You must own them for more than 60 days out of a 121-day period that begins on the date you purchased the stock if you purchased common stock. The holding period requirement is longer for preferred stock: more than 90 days out of a 181-day period that begins with your date of purchase, referred to as the ex-dividend date. Mutual fund stocks are subject to the same timeframe as common stock.
Finally, they can’t be cited on the IRS's list of “dividends that are not qualified.”
What Is Considered an Ordinary Dividend?
Identifying an ordinary dividend is much easier. Your dividends are ordinary if they don’t meet any of the criteria for being qualified. An ordinary dividend is basically a non-qualified dividend.
They include dividends paid by tax-exempt organizations or through an employee stock ownership plan or ESOP. Dividends are ordinary if you’re obligated to make related payments to obtain other, similar stocks or properties.
Ordinary dividends are far more common than qualified dividends, according to the IRS. They’re not capital gains. They’re paid out of earnings. As such, they’re taxed to you as regular income, usually at higher tax rates, up to 37 percent according to current tax brackets.
How Do I Know if My Dividend Is Ordinary or Qualified?
The easiest way to determine whether your dividends are ordinary or qualified is to rule them out as being qualified according to these rules. Or you can simply consult Form 1099-DIV that you should receive from the corporation or entity that paid you.
Consult with a financial advisor if you’re not sure because you’ll want to report them correctly to the IRS on your tax return and pay the appropriate tax rate.
The Effect of Dividends on Your Taxes
Dividend income is taxable income. The IRS indicates that you should receive a Form 1099-DIV reporting your dividends to you and to the IRS if you received distributions of $10 or more. Ordinary dividends appear in box 1a of the form. Qualified dividends appear in box 1b.
These amounts must then be transferred to your Form 1040 tax return on line 3a for qualified dividends or line 3b for ordinary dividends. You must also report ordinary dividends on Schedule B, “Interest and Ordinary Dividends,” if you receive more than $1,500. Include this form when you file your tax return.
Ordinary dividends are taxed according to ordinary income tax brackets, while qualified dividends are taxed at kinder capital gains tax rates of 0 percent, 15 percent or 20 percent. And yes, you must still report your dividends as income even if you turn right around and invest the money in more stock.
Watch Out for the Net Investment Income Tax
The net investment income tax is an additional tax over and above the capital gains rate you’ll pay on qualified dividends or the income tax rate you’ll pay because you have ordinary dividends. This tax was first implemented in tax year 2013.
But here’s a bit of good news: This tax only targets high earners. It’s imposed on married taxpayers who file joint returns at modified adjusted gross incomes of $250,000 or more, dropping to $200,000 for single filers and all the way down to $125,000 if you’re married and file a separate return, according to the IRS.
The IRS advises that you should make estimated tax payments quarterly throughout the year if you’re subject to this tax. You may find yourself subject to a tax penalty otherwise. The tax is applied to your investment income or the amount of your income over these thresholds, whichever is less, at a rate of 3.8 percent.
Beverly Bird has been writing professionally for over 30 years. She is also a paralegal, specializing in areas of personal finance, bankruptcy and estate law. She writes as the tax expert for The Balance.