Qualified Dividend. MarketCheese

A qualified dividend – is a specific type of dividends that falls under a different taxation treatment than regular dividends (either ordinary or preferred ones). Qualified dividends are taxed as a capital gain, while other dividends are taxed as a regular income. Typically, this taxation treatment of qualified dividends is more advantageous for an investor because it’s lower than income tax rates. The difference between the capital gains and income taxes might be substantial. As an example, let’s take a look at the US rates in 2021-2022. The capital gains tax has varied from 0% to 20%, depending on the certain requirements, while the income tax has varied from 10% to 37%. Note that particular rates may vary in different countries, regions, or states.

Qualified dividends have to meet certain requirements of a tax agency in order to be considered so. For example, in the US, these requirements are stated by the Internal Revenue Service (IRS).

Before 2003 all dividends were taxed similarly. However, since that time the situation has changed, and dividends have been classified as qualified and unqualified, or ordinary. The reason for different taxation treatment of qualified dividends is the companies’ intention to reward and support their long-term investors.

Taxation treatment of Qualified Dividends

The Internal Revenue Service (IRS) in the US has a special form on dividends, it’s 1099-DIV. This form includes all the related information on the taxation of dividends that investors should be aware of. There are two variants of this form:

Box 1a is for ordinary dividends, which are the most common ones.
Box 1b is designed specifically for qualified dividends.

The suitable tax form is sent to investors, who gain dividend payments from their investments during a calendar year.

Now let’s take attention to the numbers. As we mentioned before, the capital gains tax in the US usually varies from 0% to 20%. At least these numbers are true for recent years. The tax brackets change according to a person’s ordinary income and marital status:

If the person’s ordinary income is regularly taxed at 10-12% (which means that the person’s income per year varies from $41,675 to $83,350 depending on the marital status), then the tax on qualified dividends will be 0%.
If the ordinary income is taxed at 12-35% (the annual income is above the previous numbers, but below $459,750 if the person is singe or $517,200 if the person is married and supports the spouse), the gain capital tax will be 15%.
In case the person’s income is taxed at 35-37%, and the annual income is above the previous numbers, the qualified dividends will be taxed at 20%.

These numbers don’t represent all the taxation treatment aspects and might change with time, but they quite vividly demonstrate the huge difference between capital gains and income taxes. As you can see by this example, it might be reasonable for investors to have some shares with qualified dividends instead of ordinary ones.

Requirements for Qualified Dividends

The IRS states the following rules that have to be applied to the qualified dividend:

the dividend has to be paid by a qualifying company;
the dividend has to be listed as qualified in the IRS;
an investor has the dividend for a required holding period.

All these rules require some explanation. First, according to the IRS, a company is seen as qualifying if it’s incorporated in the US (even if it’s a foreign company), and its securities are traded in the US stock markets. Also, it might have a benefit of a comprehensive income tax treaty. If any of these conditions is met by the company, then it’s considered to be the qualifying one.

Also, the IRS outlines some dividends that can’be seen as qualified at any conditions. These restrictions concern the shares of companies which generate income by selling and buying real estate, tax-free companies, and master limited partnerships (MLPs). Hedge funds dividends, one-time dividends, and interests from bank deposits aren’t considered as qualified as well.

Finally, the last requirement for qualified dividends stated by the IRS is about a certain period of time that an investor should have shares in a portfolio. Otherwise, it’s known as the holding period. This period is different for different types of shares. Usually, the holding period for the ordinary shares is 60 days or more within the period of 121 days, starting from the date of the previous dividend payment. Preferred shares have to stay in the investor’s portfolio for at least 90 days within the period of 181 days, starting with the ex-dividend date as well. For mutual funds, these restrictions might be slightly different. Typically, the mutual fund’s shares have to be owned for at least 61 days within the 121-years period.

Note that when you sell shares with qualified dividends, the day of sale is still counted in your holding period, however, the day of purchase isn’t counted.

Example of Qualified Dividends

Let’s consider an example in order to illustrate how the holding period works. An investor purchased 500 shares of a qualifying company A on March 1, and sold 150 of them on April 1. The ex-dividend date was March 15. Therefore, dividends for 150 shares that were sold couldn’t be taxed as qualified because the investor held them only for 31 days out of 121-days period. Meanwhile, the dividends for 350 shares left in the portfolio at least until May 1 would be taxed as a capital gain.

Meaning of Qualified Dividends in an investor’s portfolio

We have to mention that for the US investors the question of having shares with qualified or unqualified dividends isn’t much of a question because most shares of the US companies are met the IRS requirements and considered to be qualified, excluding only some of them (e.g., real estate investment trusts or master limited partnerships). Foreign investors have to check the information on qualified dividends more carefully.

Moreover, there is actually not much that investors can do except for choosing the stock of the qualifying companies and controlling the shares’ holding period. Other factors and requirements are mostly out of their control.