Dividends are payments made by a company to its shareholders, usually on a quarterly basis. They represent a portion of the company’s profits and are a way for shareholders to earn income from their stock investments. However, not all dividends qualify for the special low tax rates that were originally intended to benefit investors. Only dividends that meet certain requirements are considered “qualified dividends”.
Qualified Dividend Definition
Qualified dividends are ordinary dividends from domestic corporations and certain foreign corporations that qualify for the lower long-term capital gains tax rates (rather than ordinary income tax rates) if you meet holding period requirements.
The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the tax rates on long-term capital gains and qualified dividends. Long-term capital gains and qualified dividends are currently taxed at a top rate of 20% for individuals in the highest ordinary income tax bracket. For those in lower tax brackets, the rate can be as low as 0%. This is a significant saving against ordinary income, which is taxed at 37%
These reduced tax rates were originally scheduled to expire after 2008 but have been repeatedly extended. Under current law, the reduced rates will expire at the end of 2025.
Qualified Dividends Pros and Cons
- Preferential tax rates (0%, 15% or 20%) vs. higher ordinary income rates
- Ability to harvest losses without violating the wash sale rule
- Rewards long-term investors and reduces turnover
- Provides a steady income stream during retirement
- Incentivizes investment in domestic corporations
- Tax rates could rise if laws change in the future
- Have to hold stocks for 60+ days around ex-date to qualify
- Dividend-focused investing can overweight certain sectors
- Company performance still determines dividend payments
- Dividend growth (not just stability) is needed to fight inflation over time
- Dividend yields tend to fall as stock prices rise, which may serve to reduce income long-term
- International dividends have foreign taxes and currency risk
The lower tax rates on qualified dividends can provide tangible tax savings for eligible investors. However, dividends do still carry risks such as lower yields over time and reliance on corporate profitability. Investors should weigh the pros and cons and not overly concentrate their portfolios on dividends (qualified or otherwise) alone. A diversified, balanced asset allocation is usually the best approach. Periodic rebalancing and diversification should be maintained.
For a dividend to be considered qualified, it must meet several criteria:
- It must be paid by a U.S. corporation or a qualifying foreign corporation. Interest payments, dividends from money market accounts, etc. do not qualify.
- The stock must be held for a minimum holding period surrounding the ex-dividend date, which is typically about two months.
- The dividends cannot be listed under the IRS’s non-qualified dividend list, which includes things like REIT dividends, master limited partnership income, etc.
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Which Foreign Corporations Qualify?
Foreign (non-U.S.) corporations can pay qualified dividends, but they must meet certain criteria:
- The corporation must be incorporated in a U.S. possession, such as Puerto Rico.
- For other foreign corporations, the stock must be readily tradable on a major U.S. stock exchange, such as the NYSE or NASDAQ.
- The country must have a comprehensive tax treaty with the U.S. that the IRS recognizes as allowing for qualified dividends.
Common foreign corporations that may pay qualified dividends include companies domiciled in Australia, France, Germany, Taiwan, and the United Kingdom. The IRS provides a full list of countries with qualifying tax treaties.
Examples of Qualified Dividends
Here are some examples of dividends that would qualify for the lower tax rates:
These are major U.S. corporations traded on the NASDAQ. As long as you meet the holding period requirement, their dividends would be qualified.
- HSBC (HSBC)
HSBC is headquartered in the U.K., which has a qualified tax treaty with the U.S. Its ADRs trade on the NYSE as HSBC. Its dividends would be qualified.
- Rio Tinto (RIO)
Rio Tinto is an Australian company traded on the NYSE. Australia has a qualifying tax treaty with the U.S., so Rio Tinto’s dividends would qualify.
Examples of Non-Qualified Dividends
- Money market or savings accounts
Interest does not qualify for the reduced dividend rates.
- REIT dividends
Real estate investment trust dividends are specifically listed by the IRS as non-qualified dividends.
- MLP distributions
Master limited partnership income does not qualify. MLPs issue K-1s, not 1099-DIVs.
- Foreign corporation without treaty
A foreign company traded over-the-counter or on a foreign exchange would not qualify unless it met other criteria.
Qualified Dividends Holding Period Requirements
To satisfy the holding period requirement, an investor must own the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.
Additionally, it’s not permitted to enter into positions that offset your risk of loss for the stock during that 121-day window (such as covered calls). The holding period prevents investors from buying stocks right before the ex-dividend date just to receive the dividend.
This isn’t to say that an investor isn’t allowed to buy and sell dividend stocks whenever they want, of course. But doing so outside of these requirements means no availment of the qualified dividends benefits. For this, it’s important to demonstrate a longer-term commitment to the investment in order to reap the additional financial benefits.
How Qualified Dividends Are Taxed
Qualified dividends are reported to you on Form 1099-DIV from your brokerage. The dividends will be denoted as either qualified or non-qualified.
Individuals must report all ordinary dividends on their tax return. Qualified dividends get preferential tax treatment, while non-qualified dividends are taxed at the ordinary income tax rate.
For the purpose of a real example, here were the applicable tax rates based on an investor’s filing status and income for the 2022 fiscal year:
- 0% for incomes up to $41,675
- 15% for incomes over $41,675 up to $459,750
- 20% for incomes above $459,750
Married Filing Jointly:
- 0% for incomes up to $83,350
- 15% for incomes over $83,350 up to $517,200
- 20% for incomes above $517,200
So if an investor was a single filer with $60,000 in income, any qualified dividends would be taxed at the 15% rate. If the income was $500,000, then qualified dividends would have been taxed at 20%.
Non-qualified dividends are taxed at the ordinary income rate, which could be as high as 37% depending on an investor’s regular tax bracket.
How to Calculate Taxes on Qualified Dividends
Here’s an example to demonstrate how to calculate taxes on qualified dividends:
Let’s say you are single and have $100,000 in taxable income, including $5,000 in qualified dividends. Your ordinary income tax rate is 24%.
Here is how you would calculate taxes:
- Ordinary income: $100,000 – $5,000 qualified dividends = $95,000 taxed at 24% ordinary rate
- Tax on ordinary income: $95,000 x 24% = $22,800
- Qualified dividends: $5,000 taxed at 15% preferential rate
- Tax on qualified dividends: $5,000 x 15% = $750
Total tax = $22,800 + $750 = $23,550
So your total tax bill would be $23,550. Without the qualified dividend rates, your tax on the full $100,000 would be $24,000. So your qualified dividends saved you $450 in taxes.
Tax Calculation Key Takeaways:
- Calculate ordinary income tax separately from qualified dividends.
- Qualified dividends are taxed at the preferential rates of 0%, 15% or 20% based on income.
- The qualified dividend rates can result in significant tax savings versus ordinary rates.
Tax Loss Harvesting with Qualified Dividends
Tax loss harvesting involves selling securities at a loss to offset realized capital gains and income. The realized losses can then be used to lower any tax liability.
However, investors cannot claim a loss on the sale of a stock if they buy back that same stock within 30 days. This is known as the wash sale rule.
But this rule does not apply when harvesting losses on qualified dividend stocks. The IRS allows investors to harvest losses on dividend stocks and immediately buy back the same stock without violating the wash sale rule.
This provides investors more flexibility when tax loss harvesting via qualified dividend paying stocks. You can maintain your dividend stream without running afoul of the wash sale rule.
Strategies for Qualified Dividends
As with any other facet of investment, there are plenty of strategies at your disposal, depending on the overall investment goal:
- Purchase Dividend Stocks Prior to the Ex-Dividend Date: By buying dividend stocks before the ex-dividend date and holding them for the required period, investors ensure they receive the upcoming dividend payout. This strategy allows investors to capture regular income streams, providing a predictable source of cash flow. Marking the calendar in advance helps in planning and ensures you don’t miss out on dividend payments.
- Focus on Established, Blue-Chip Stocks: Investing in established, blue-chip stocks that consistently increase their dividends offers a reliable income stream. These companies are known for their stability and tend to weather economic downturns better than smaller companies. Investors benefit from the assurance of a steady dividend income, contributing to long-term financial security.
- Place Dividend Stocks in Tax-Advantaged Accounts: Storing dividend-paying stocks in tax-advantaged accounts, like IRAs, can be highly advantageous. It allows investors to defer or even eliminate taxes on dividend income, thereby maximizing their after-tax returns. This strategy is particularly beneficial for long-term investors looking to compound their wealth.
- Consider International Dividend Stocks: Holding international dividend stocks in accounts without qualified dividend benefits can be a smart move. Many countries offer foreign tax credits, which may result in more favorable tax treatment compared to qualified dividend rates. This approach broadens your investment portfolio and potentially enhances tax efficiency.
- Harvest Losses on Qualified Dividend Stocks: Harvesting losses on qualified dividend stocks can offset gains and provide tax benefits. However, it’s crucial to be mindful of the wash sale rule, which restricts buying back a substantially identical security within 30 days. This strategy can help optimize your tax liability while managing your portfolio.
- Compare After-Tax Income with Municipal Bonds: When investing for income, it’s essential to weigh the pros and cons of qualified dividend stocks against alternatives like municipal bonds. Comparing after-tax income from both options can help investors make informed decisions. Municipal bonds offer tax-free interest income, and evaluating these choices ensures you choose the most tax-efficient investment for your financial goals.
By understanding and implementing these strategies, U.S. investors can not only maximize their qualified dividend income but also enhance their overall financial end-goals.
Qualified Dividends vs. Ordinary Dividends
Here is a summary comparing qualified dividends to ordinary dividends:
- Must meet the ex-date holding period.
- Paid by U.S. and qualified foreign corporations.
- Taxed at long-term capital gains rates up to 20%.
- No wash sale rule when harvesting losses.
- All other dividends that don’t meet qualified criteria.
- No special holding period requirements.
- No corporate qualification rules.
- Taxed at ordinary income tax rates up to 37%.
- Subject to wash sale rule when harvesting losses.
- Qualified dividends require holding periods but offer the reward of significantly lower tax rates.
- Ordinary dividends are taxed at higher rates but with greater flexibility for harvesting losses.
Wrapping Up: Qualified Dividends Conclusion
Qualified dividends represent an opportunity for investors to gain preferential tax treatment on their dividend income. By meeting holding period requirements, investors can take advantage of the maximum 20% tax rate on qualified dividends versus the 37% top rate on ordinary income.
Savvy investors pay close attention to the ex-dividend dates on their holdings. Careful tax planning, including tax-advantaged accounts and loss harvesting, can help maximize after-tax returns. While the lower qualified dividend rates provide benefits today, they are scheduled to sunset at the end of 2025 barring any changes or extensions to the current tax law.
Focusing solely on dividend yield can lead to concentration risk and reduced total returns over time as stock prices appreciate. Maintaining a diversified asset allocation appropriate for your goals and risk tolerance is important, but strategic use of qualified dividends can be a way to enhance after-tax income in many long-term portfolios.
Frequently Asked Questions
- What’s the difference between qualified and ordinary dividends?
Qualified dividends meet holding period requirements and other criteria to be taxed at lower long-term capital gains rates instead of higher ordinary income rates. Ordinary dividends don’t qualify for the lower rates.
- What are the current qualified dividend tax rates?
For 2023, qualified dividends are taxed at 0%, 15% or 20% for most taxpayers depending on their ordinary income tax bracket.
- Do I have to hold a stock for a year to qualify for the lower dividend tax rates?
No, you only need to hold the stock for 60+ days of the 121-day period surrounding the ex-dividend date. The required holding period is not a full year.
- What are some examples of foreign companies that can pay qualified dividends?
Some examples include HSBC (U.K.), Novartis (Switzerland), Samsung (South Korea), and Toyota (Japan). The foreign corporation must meet requirements such as being in a country with a qualifying U.S. tax treaty.
- Can MLP dividends qualify for the lower tax rates?
No, master limited partnership (MLP) distributions are specifically listed by the IRS as non-qualified. MLPs issue K-1s instead of 1099-DIVs.