What Are Qualified Dividends? Knowing Might Save You Money

You may already know what a dividend is, but did you know that dividends come in two flavors? It’s true, and understanding their distinctions can make a difference in your tax bill. In short, you’ll likely pay a different tax rate on ordinary vs. qualified dividends. While ordinary dividends are generally subject to your standard income tax rates, qualified dividends are taxed at the capital gains rate, which may mean tax savings. This article breaks it down for new investors.

In this article, we’ll cover:

• A dividends recap
• Ordinary vs qualified dividends
• What a qualified dividends mean

Dividends: a quick primer

A dividend is money a company pays to its shareholders, and it represents a portion of the company’s profits. Dividends are proportional to the amount of stock you own, so if you owned 10% of the company’s outstanding stock, you’d get 10% of the total dividend. Whether you own your shares directly or through a mutual fund or exchange-traded fund (ETF), you’re entitled to dividends.

Dividends are usually paid in cash, although they can be paid in other ways, like more stock. U.S. companies often, but not always, pay them quarterly. Companies typically don’t distribute all their profits in the form of dividends; some are retained for growth, debt payments, and so on. And not all companies pay dividends. What’s more, high dividend stock isn’t right for every portfolio.

Ordinary vs. qualified dividends: Why does it matter?

Dividend income is taxable, even if you reinvest it in the company by buying more stock. In some cases, dividends paid in the form of additional stock are taxable too. 

How much tax you owe depends on the type of dividend. The IRS categorizes all dividends as either ordinary or qualified. Ordinary dividends are subject to your standard income tax rate, while qualified dividends are taxed at lower capital gains rates. 

Note that dividends paid by stocks held in a tax-favored retirement account, like a 401k or IRA, are taxed in the same way as any other earnings in those accounts, so you generally won’t pay taxes on such dividends every year. 

How can I tell if I have ordinary vs. qualified dividends?

Anyone who pays you a dividend is required to send you a 1099-DIV tax form, which has a handy set of boxes to answer that question. Box 1a lists ordinary dividends that are ordinary, and qualified dividends are listed in box 1b. 

But heads up: the IRS doesn’t consider some dividends qualified even if they’re listed in box 1b. Exceptions are laid out in the dividends that are not qualified dividends list; more on that later in this article.

What are qualified dividends?

According to the IRS, a dividend must meet three criteria to qualify:

• The company that paid it must be a U.S. corporation or a “qualified foreign corporation”
• The dividend type cannot be on the IRS’s “Dividends that are not qualified dividends” list 
• You must have owned the stock for 60 to 90 days during a specific window of time. This is called “meeting the holding period” in finance-speak

Let’s explore the meaning of these criteria in more depth.

Qualified foreign corporations

The IRS has rules defining which foreign corporations are qualified, and this article offers more information about investing in foreign corporations.

The “dividends that are not qualified dividends” list

The IRS maintains a list of dividends that can never be considered qualified, even if they’re listed in box 1b of the 1099-DIV. It includes dividends obtained via derivatives or short strategies, as well as dividends from Real Estate Investment Trusts (REITs) and REIT ETFs.

REITs own and manage real estate properties, distributing the proceeds, including rental income, to investors. Investors are responsible for paying taxes on dividends and capital gains paid out by a REIT; dividend payments are typically considered ordinary income at tax time.

Meeting the holding period

The holding period measures how long an investor has owned or “held” a stock. The purpose of the holding period is to create an incentive for investors to hold onto their stock and encourage companies to reward their long-term shareholders. 

If you’re holding onto your stock as part of a long-term investment strategy, you’ll almost certainly meet the holding period, because you only need to hold your stock for 60 days during a specific period of time. But it’s conceivable that dividends on stock you purchased recently might not meet the holding period.

Here’s what the IRS says about the holding period: “You must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date… When counting the number of days you held the stock, include the day you disposed of the stock, but not the day you acquired it.”

The rules about the holding period can get a little tricky, so let’s break it down in everyday language. First, you’ll want to understand the ex-dividend date.

Companies announce dividends ahead of time. A company that pays dividends quarterly, for instance, would make a dividend announcement four times a year. When they make the announcement, they set a date by which investors must be on the company’s records as shareholders to receive the dividend; this is the “record date.” If you aren’t a shareholder by the record date, you won’t get the dividend.

But wait, there’s more: the business day before the record date is called the ex-dividend date. If you buy stock on the ex-dividend date, you won’t be considered on the company’s records as a shareholder, so you won’t get the dividend. That means the last day you can buy stock, if you want to get the dividend for that period, is the business day before the ex-dividend date.

Of course, you can still buy stock on the ex-dividend date, or any date after that. You just won’t get the dividend the company announced for that period. But if you hang onto your stock long enough, you can likely catch the next one.

How to determine if you’ve met the holding period

Once you know the ex-dividend date for a stock, you’ll need to do some simple math to see if you’ve met the holding period defined by the IRS. 

• 60 days before the ex-dividend date. First, go back 60 days from the ex-dividend date and write that date down.
  
• The 121-day period that began 60 days before the ex-dividend date. Starting with the date you wrote down in the prior step, go 121 days forward, and write down that date. That’s the 121-day period you need for the next step.
  
• More than 60 days out of the 121-day period that began 60 days before the ex-dividend date. Look at the dates you wrote down in the two prior steps. Did you own the stock for more than 60 days during the 121-day period?

To answer the question, remember the last part of the IRS’s definition: “When counting the number of days you held the stock, include the day you disposed of the stock, but not the day you acquired it.” So when you count up the 60 days, don’t include the day you bought the stock. If you’ve sold the sock, do include the date you sold.

If you count more than 60 days, congratulations; you’ve met the holding period and your dividend is qualified, provided the other criteria are met. If you count 60 days or fewer, your dividend is ordinary income.

If you have preferred stock, the holding period is longer; usually 90 days. There may also be other differences in the tax treatment of dividends. 

Explore dividends with Stash

“What are qualified dividends?” is a smart question for any investor to ask, because a thorough understanding of the answer can help you make investing decisions that affect how much tax you might pay on any dividends you earn. Armed with this knowledge, you can take a strategic approach to when you buy and sell stock based on whether you’ll wind up with ordinary vs. qualified dividends. 

Stash offers many stocks and ETFs that pay dividends, and by following the Stash Way of holding onto investments for the long term, your dividends are more likely to be qualified. That means potential tax savings, plus more money in your pocket or in your investment portfolio if you reinvest your dividends. 

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