When you receive a dividend payment from company stocks, it will fall into one of two categories for tax purposes. Qualified dividends are more beneficial than nonqualified dividends since these payouts have lower tax rates. Not all dividends are qualified, however, and you will have to hold the stock for a certain period to enjoy the reduced tax rate.
Qualified dividends are a type of dividend that is eligible to incur capital gains tax rather than income tax. This typically results in a lower tax bill for the investor.
Qualified Dividends Explained
Every investor hopes for strong returns on her stock portfolio, and the way in which your dividends are taxed can have a major impact on the maximum return on investment. If you receive qualified dividends, you will pay capital gains tax rather than income tax. Since capital gains tax rates are customarily lower than income tax rates, qualified – as opposed to nonqualified – stocks can save money on your tax bill.
Criteria for Qualified Status
Some types of dividends cannot be qualified dividends, including dividends paid out by real estate investment trusts, employee stock option plans and bank deposits. Overall, most dividends paid out by U.S. corporations are qualified and taxed at the reduced capital gains tax rate. Dividends paid out by foreign companies are also qualified in certain circumstances, for example, where there is a tax agreement in place between the foreign entity's home nation and the Internal Revenue Service.
Minimum Holding Period Applies
Investors must hold the stock for a minimum wait period to receive the reduced tax rate. For common stocks, the period is more than 60 days during a 120-day window that begins 60 days before the "ex-dividend date," or the first day a stock trades without a previously declared dividend. Assuming a stock's ex-dividend date is June 1, for example, then you must hold the shares for more than 60 days in the window between April 2 and July 30 of the same year for it to count as a qualified dividend.
Qualified Dividends Vs. Nonqualified Dividends
If a dividend is not "qualified" it is "nonqualified" or "unqualified," and the holder must pay income tax rates. The difference can be quite substantial when the time comes to pay taxes. For example, Maria is in the 28-percent tax bracket and she owns 10,000 shares of Acme Corporation stock which pays $0.10 per share in annual dividends. Since Acme pays qualified dividends, Maria must pay capital gains tax at 15 percent on her $1,000 dividend payout, giving her a tax bill of $150. Had the dividends been nonqualifying, she would have paid income tax on the dividends for a tax liability of $280.