There are two types of dividends paid out to investors: Ordinary and Qualified. The time an investor has owned a stock determines whether the dividend will be considered Ordinary or Qualified. The other difference between these is the tax treatment of the dividend.
Previously, all dividends were considered Ordinary dividends with taxes owed at their marginal rate. Since a 2003 tax law change, dividends have been a focal point for companies and investors looking to get favorable tax treatment.
These dividends are taxed as ordinary income, an investor must pay Federal tax on the income at their ordinary income tax rate.
Most mutual fund and corporate dividends are Ordinary. Other Ordinary dividend payers include money market funds, banks, real estate investment trusts, master limited partnerships, employee stock ownership plans, and foreign corporations.
The rules on Qualified dividends are a bit more complicated. According to the IRS, for shares of domestic corporations to qualify, they must be owned for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. This is the earliest date after a dividend is declared that a buyer won’t be entitled to get the declared dividend. For preferred shares, the stock must be owned more than 90 days during the 181 days starting 90 days before the ex-dividend date.
Qualified dividends are taxed at capital gain rates with lower-income recipients potentially owing no Federal tax at all. The tax rules for Qualified dividends are as follows:
For high-income filers whose marginal tax rate is the maximum 37%, 20% tax on income is owed.
Filers whose marginal rate is between 15-37% owe 15%.
Filers whose income would be taxed at 10% or 15% would owe no Federal income tax.
It can be difficult for dividend investors to tell how their income from dividends will be taxed. Fortunately, dividend payers report the information about dividend type and amount to taxpayers and the IRS using the 1099-DIV form. Generally, dividends are likely to be Qualified for stocks that have been owned for more than a few months.