.png)
In This Article
When investing in dividend-paying stocks or other securities, understanding the tax implications is vital for maximizing your returns. Dividends, which represent a share of a company’s earnings paid out to shareholders, can be a reliable source of income. However, not all dividends are taxed the same. In fact, the IRS classifies dividends into two categories—ordinary dividends and qualified dividends—each of which is subject to different tax rates.
This distinction is more than a matter of terminology; it can impact your tax liabilities and overall investment strategy.
So, exactly what is difference between ordinary and qualified dividends?
This article will break down the key differences, the tax treatment of each type of dividend, and how to make informed decisions to optimize your dividend income.
What Is Dividend Income?
Dividend income refers to the money that investors receive from companies as a reward for holding shares. Dividends can be issued in the form of cash payments or additional stock shares, depending on the company’s policy.
For many investors, dividend income serves as a steady stream of passive income, supplementing other sources of revenue such as wages or capital gains from the sale of assets. Dividends are a common way for well-established companies to share profits with shareholders, making them an attractive option for income-focused investors.
Dividend income can be particularly appealing because it offers a predictable income stream, especially from companies with a long history of paying and increasing dividends. However, the way dividends are taxed—whether they are ordinary or qualified—has a significant impact on your net returns.
What Is a Qualified Dividend?
A qualified dividend is a dividend that meets specific IRS criteria, allowing it to be taxed at the more favorable long-term capital gains tax rate. For a dividend to be considered qualified, it must meet the following conditions:
Issued by a U.S. corporation or a qualified foreign corporation: Most dividends from major U.S. companies are qualified, as are dividends from certain foreign corporations that meet IRS requirements.
Holding period: To qualify for the lower tax rate, you must hold the stock for at least 60 days during the 121-day period that begins 60 days before the ex-dividend date. For preferred stock, this period extends to 90 days during the 181-day period that begins 90 days before the ex-dividend date.
Investment type: The dividend must not come from investments such as Real Estate Investment Trusts (REITs), Master Limited Partnerships (MLPs), or employee stock options. Dividends from these sources are typically classified as ordinary dividends and taxed at the higher ordinary income tax rate.
The goal of these rules is to encourage long-term investment in companies, which helps promote economic stability. By holding onto stocks for a more extended period, investors benefit from lower tax rates on their dividend income, while companies enjoy a more stable shareholder base.
What Is a Non-Qualified Dividend?
Any dividend that does not meet the IRS’s criteria for being "qualified" is classified as a non-qualified dividend. These dividends are taxed at your standard income tax rate, which can be as high as 37%, depending on your tax bracket.
Non-qualified dividends are often paid by investments like REITs, MLPs, or foreign companies that don’t meet the IRS's specific standards for qualified dividends. Additionally, if you do not meet the holding period requirement for a dividend-paying stock, the dividends you receive from that stock will be classified as non-qualified.
Given the higher tax rates on non-qualified dividends, it's essential to differentiate between ordinary and qualified dividends to optimize your investment strategy.
What is Difference Between Ordinary and Qualified Dividends?
At its core, the difference between ordinary and qualified dividends lies in how they are taxed. Here's a breakdown:
Ordinary Dividends | Qualified Dividends |
These are taxed as ordinary income, which means they are subject to the same tax rates that apply to wages, salaries, and other forms of earned income. The federal income tax rates for ordinary dividends can range from 10% to 37%, depending on your taxable income and tax bracket. | These receive favorable tax treatment because they are taxed at the long-term capital gains tax rate, which is generally lower than ordinary income tax rates. The long-term capital gains tax rate ranges from 0% to 20%, depending on your income level. This rate makes qualified dividends more attractive for investors seeking tax-efficient income. |
Understanding this distinction is crucial because it can greatly affect how much of your dividend income you keep after taxes. To take full advantage of lower tax rates, it’s important to ensure your dividends meet the criteria to be considered qualified.
How Are Ordinary Dividends Taxed?
Ordinary dividends are taxed as ordinary income, meaning they are subject to the same federal income tax rates as your wages, salary, or other earned income. Federal tax rates for ordinary dividends range from 10% to 37%, depending on your income level.
For example, if you’re in the 24% tax bracket and receive $5,000 in ordinary dividends, you’ll owe $1,200 in federal taxes on that dividend income.
The fact that ordinary dividends are taxed at a higher rate than qualified dividends can make a significant difference in your overall returns, especially for high-income earners. Investors who receive large amounts of ordinary dividends should consider strategies to minimize their tax liabilities, such as holding dividend-paying stocks in tax-advantaged accounts like IRAs or 401(k)s.
Taxation of Qualified Dividends
Qualified dividends are taxed at the long-term capital gains tax rate, which is lower than the short-term capital gains rate. Long-term capital gains tax rates range from 0% to 20%, depending on your taxable income. Here’s a breakdown of the 2023 tax rates for long-term capital gains (which apply to qualified dividends):
0%: Applies to single filers with taxable income up to $44,625 or married couples filing jointly with income up to $89,250.
15%: Applies to single filers with taxable income between $44,626 and $492,300 or married couples with income between $89,251 and $553,850.
20%: Applies to single filers with taxable income over $492,301 or married couples with income over $553,851.
This means that investors with qualified dividend income benefit from significantly lower tax rates, making it an attractive way to generate tax-efficient income. For high-income earners, qualified dividends can save thousands of dollars in taxes compared to ordinary dividends.
Explore more resources on Dividend Horizon for expert insights.
Dividend vs Capital Gain: What’s the Difference?
A key part of understanding dividend taxes is knowing the difference between dividend vs capital gain. Both represent forms of investment income, but they are taxed differently and arise from different circumstances.
Dividends | Capital Gains |
Paid out regularly by companies to shareholders from their profits. Dividends can be classified as either ordinary or qualified, with the latter being taxed at a lower rate. | Represent the profit from selling an asset, such as a stock, at a higher price than the purchase price. Capital gains can be either short-term (held for less than one year and taxed as ordinary income) or long-term (held for more than one year and taxed at the lower long-term capital gains rate). |
For investors, balancing dividend income with capital gains is a key strategy in managing their tax liabilities and overall returns.
Dividend vs Distribution: Key Difference
Another distinction investors should be aware of is the difference between dividend vs distribution. While both represent a form of income from investments-
dividends typically come from corporate stocks
distributions often come from other investment vehicles like partnerships, mutual funds, or trusts.
Dividends | Distributions |
Typically paid out by corporations to shareholders from their profits. They are taxed as either ordinary or qualified dividends, depending on how long the stock was held and whether the company meets IRS requirements. | Can be payouts from entities such as mutual funds, REITs, or MLPs. Distributions are often treated as ordinary income and taxed at a higher rate than qualified dividends. |
Investors must understand the nature of the income they receive from their investments to optimize their tax strategy. For example, holding dividend-paying stocks in a tax-advantaged account can reduce the tax burden, while distributions from certain funds may have different tax implications.
How Do You Know if Dividends Are Qualified or Ordinary?
Determining whether your dividends are ordinary or qualified is straightforward. Every year, your brokerage or financial institution will send you an IRS Form 1099-DIV, which breaks down your dividend income:
Ordinary dividends in Box 1a
Qualified dividends in Box 1b
However, not all investments make it easy to distinguish between qualified and ordinary dividends. Investors holding shares in foreign companies or alternative investments like REITs or MLPs may need to consult with their broker or a tax professional to determine the classification of dividends.
If you’re uncertain whether your dividends qualify for lower tax rates, it’s a good idea to seek professional advice, especially if you have a diverse portfolio that includes international stocks or alternative investment vehicles.
Examples of Qualified Dividends
To clarify, here are some examples of qualified dividends:
Dividends paid by U.S. companies like Coca-Cola, Apple, or Procter & Gamble that meet the IRS’s holding period requirements.
Dividends from shares in mutual funds or ETFs that hold qualified stocks, provided the mutual fund itself qualifies.
Dividends paid by certain foreign companies that are listed on U.S. stock exchanges and meet IRS criteria for qualified dividends.
For more insights on how qualified dividends can help you achieve financial independence, I recommend you check out my book Dividend Horizon’s guide on living off dividends. This will prepare you for your dividend investment journey.
Do You Pay State Income Tax on Qualified Dividends?
In addition to federal taxes, investors may also be subject to state income tax on qualified dividends, depending on their state of residence. Some states, like California and New York, tax all forms of income, including dividends, while other states, such as Florida and Texas, have no state income tax.
Investors in high-tax states may benefit from holding dividend-paying stocks in tax-advantaged accounts to reduce their overall tax burden.
Minimize Taxes on Dividend Income
Here are some strategies to minimize taxes on dividend income:
Hold dividend stocks in tax-advantaged accounts: Investing in a Roth IRA, Traditional IRA, or 401(k) allows dividends to grow tax-free or tax-deferred.
Focus on qualified dividends: By investing in stocks that pay qualified dividends, you can take advantage of the lower long-term capital gains tax rate.
Reinvest dividends: Consider using a Dividend Reinvestment Plan (DRIP) to reinvest your dividends into more shares, allowing for tax-deferred growth within tax-advantaged accounts.
Diversify with tax-efficient funds: Explore dividend-focused mutual funds or ETFs that hold qualified stocks to optimize for tax-efficient income.
For a step-by-step guide on how to maximize your dividend income, check out my book that is available on Amazon or use our Dividend Calculator to simply the investment calculation.
FREQUENTLY ASKED QUESTIONS
Are qualified dividends taxed as short-term or long-term?
Qualified dividends are taxed at the long-term capital gains tax rate, which is lower than the short-term rate.
Are ordinary dividends taxed as income?
Yes, ordinary dividends are taxed as regular income at federal tax rates between 10% and 37%.
How do I know if my dividends are qualified or ordinary?
Your broker will report this information on IRS Form 1099-DIV, with ordinary dividends in Box 1a and qualified dividends in Box 1b.
What is the taxation of dividend income?
Dividend income is taxed either as ordinary income or at the lower long-term capital gains rate, depending on whether the dividends are qualified or ordinary.
Can I avoid taxes on dividends?
While you cannot entirely avoid taxes on dividends, you can minimize them. You can hold dividend-paying stocks in tax-advantaged accounts like a Roth IRA or Traditional IRA, where dividends can grow tax-free or tax-deferred. Another strategy is to focus on stocks that pay qualified dividends, as they are taxed at a lower long-term capital gains rate.
Conclusion: Optimize Your Investment Strategy with Dividend Taxes
The tax treatment of dividend income—whether it’s classified as ordinary or qualified—has a significant impact on your investment returns. By understanding the difference between the two, you can take steps to reduce your tax burden and maximize your income. Prioritize qualified dividends, utilize tax-advantaged accounts, and reinvest your earnings to build a sustainable income stream for the future.
For more insights on how to live off dividends, check out our comprehensive Dividend Horizon Blog, which provides in-depth analysis of dividend-paying stocks and strategies for maximizing your portfolio.
Ready to take control of your financial future? I recommend you join the Dividend Investing Club today. This way, you will not miss any important articles and learn to become a better investor. You will also receive your FREE 10-Step Guide to Financial Freedom!
Comments