Many people wonder whether they should be investing in qualified or non-qualified dividends and what the differences are. The largest difference is in how each is taxed. To help you determine what stock paying dividends could have a place in your individual portfolio, you should examine the company’s financial statements, dividend yield, prospects for the future and your own risk tolerance. You also determine if the dividends are regular dividends or qualifying dividends. That makes a significant difference in what stocks you invest in due to differences in taxation. A financial advisor can help you find the best dividends for your portfolio and even manage your assets on your behalf.
What Is Dividend Income?
Dividend income is part of the income stream from common stocks and it comes from a portion of the profits of a company, paid to shareholders on a regular basis. The remainder of the profits after dividends are paid out is reinvested in the firm. Not every company pays dividends to shareholders. Dividend income is especially important in times of declining stock markets since investing for value is often a more intelligent strategy than investing for growth.
Stocks with a substantial dividend yield are usually not rapidly growing. They are considered value stocks. Value investing is often an important strategy during a recession or a bear market. Dividend income is taxed. When you explore qualified vs. non-qualified dividends, you will discover the differences in taxation of distinct types of dividends.
Qualified Dividends
If the dividends you receive are classified as qualified dividends, you pay taxes on them at the capital gains rate. The capital gains rate is often lower than the tax rate on non-qualified or ordinary dividends. If you are a lower-income individual, you may have to pay no tax to the federal government on the portion of your dividends that are classified as qualified dividends.
If you receive qualified dividend income, the capital gains tax rate is 20 percent, 15 percent or 0 percent depending on your income. It is often more profitable to receive qualified dividends than ordinary dividends. Dividends must meet these criteria to be considered qualified dividends:
- The dividend must be paid by a U.S. company or a qualifying foreign company.
- If you purchase stock on or before the ex-dividend date and then hold it for at least 61 days before the next dividend is paid, then the dividend is a qualified dividend.
- The stock must meet the holding period. For dividends to be taxed at the capital gains rate, the holding period may be 60 days for mutual funds and common stock and 90 days for preferred stock. If you don’t meet the holding period, the dividend will not be qualified.
- The dividends are not listed with the Internal Revenue Service (IRS) as those that don’t qualify for preferential status.
- Dividends must not be capital gains distributions or payments from tax-exempt organizations.
Ordinary (Non-Qualified) Dividends
Most dividends paid by a corporation are ordinary dividends and do not conform to the criteria for qualified dividends. This means they are taxed at your individual marginal income tax rate. The marginal tax rate is the income tax rate paid on the last dollar of income earned by the investor. In almost every circ*mstance, qualified dividends are better for the investor than ordinary dividends.
If your tax bracket is more than 15 percent but less than the top tax bracket of 37 percent, you pay 15 percent on qualified dividends. If your tax bracket is 37 percent, you pay 20 percent on qualified dividends. This is significant when comparing ordinary dividends and qualifying dividends. A general rule that will save money is to hold investments paying ordinary dividends in tax-advantaged accounts like traditional Individual Retirement Accounts (IRA). Qualified dividends can be held in taxable accounts since the tax rate is likely lower.
The Internal Revenue Service (IRS) advises that taxpayers assume that any dividend paid on common or preferred stock is an ordinary dividend unless the issuing corporation or other body advises you differently. Businesses that almost always issue ordinary dividends rather than qualified dividends include the following:
- Banks and thrifts that pay on deposits
- Foreign corporations
- Money market funds
- Real Estate Investment Trusts (REIT), Master Limited Partnerships (MLP), Limited Liability Partnerships (LLP) and Employee Stock Ownership Plans
Dividend Reinvestment Plans (DRIPs) and payments in lieu of dividends are also taxed at a higher rate. Dividends will be reported to you on IRS Form 1099-DIV and specified as either ordinary or qualified dividends.
The Bottom Line
Dividend income is a valuable part of your return from stock investing. If you are an income, or value, investor, you usually choose stocks with higher dividend yields. Capital gains income, which comes from an increase in stock price, is important in a rising market, but dividend income takes the lead during a recessionary economy. Most dividends are ordinary dividends that are taxed at an investor’s marginal tax rate. Ordinary dividends should be held in a tax-advantaged account if possible.
Tips on Investing
- It isn’t always straightforward to determine the types of investments that you should be making. It can be wise to get professional advice from a financial advisor when investing to help you find the right mix of assets. If you don’t have a financial advisor, finding one doesn’t have to be hard. SmartAsset’s free tool can help you find a compatible financial advisor who can not only help you choose stocks based on your preferences but who can deal with the tax implications of qualified vs non-qualified dividends. You can choose between three qualified financial advisors in your local area. If you are ready, get started now.
- Not only can a financial advisor help you with your dividend income, but no matter what the market conditions are, an advisor can help you choose investments with an adequate return based on your risk preferences. Find out how much a financial advisor may cost using SmartAsset’s free tool.
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