Qualified Dividends (2024)

What are dividends and how can they impact taxes?

When a corporation earns a profit, it can choose todistribute a portion of this profit as dividends – asreturns or rewards for its shareholders. While regular dividends are paid outperiodically or on pre-set dates, companies can also pay out special dividendswhen they have earned high profits. Dividends are classified into qualified dividends andunqualified dividends, or ordinary dividends. Dividends are most commonly paidout in cash, but they can be in stocks or another type of property.

Dividendscan help you grow your investment income. Qualified dividends and ordinary dividends havedifferent holding periods requirement for taxes and different dividend taxrates, which can affect your tax rate. It is important to know the differencein dividends, so that you know how to minimize taxes.

Whatare qualified dividends?

Qualified dividends are paid bydomestic and qualified foreign corporations during a tax year. They are subjectto the maximum tax rates of 0%, 15%, or 20% that apply for long term capitalgains. Qualified dividend tax rates for individuals, trusts, and estates are at15%.

For those individuals with an income tax rate of 10% or15%, capitalgains tax becomes zero. These are shown on your Form 1099-DIV. Regulardividends paid to shareholders are usually qualified dividends and are subject to the lowercapital gain taxes while ordinary dividends are taxed at the higher regularordinary income tax rate.

Holdingperiod requirement

To enjoy the lower tax rate for the qualified dividends,investors need to meet aminimum holding period rule by the IRS. The amount of time differsfor the type of stock you hold.

For commonstocks, the shares must be held for more than 60 days during a121-day period that begins 60 days before the ex-dividend date. This is thefirst date which the stock price does not include the upcoming dividend payment.In order to receive the upcoming dividend, the holder has to own the sharesbefore the ex-dividend date. The minimum 60-day holding period rule alsoapplies to mutual funds.

For preferred stocks, the shares have to be held for over90 days during a 181-day period that begins 90 days before the ex-dividenddate.

Whatare Ordinary Dividends?

The most common form of distribution by a company or amutual fund is an ordinary dividend. Regular dividends are generally classifiedas such unless the corporation or mutual fund company states otherwise.

According to FINRAand S&P Dow Jones, about 84% of large-cap companies in theS&P 500 index pay dividends compared to around 70% and 54% for the mid-capand small-cap companies. The S&P 500 dividend yieldmost recent data was at 1.9%. If you want to search internationally, the Euro Stoxx 600 in Europe offers an enticing3.7% dividend yield.

When a company has excess profits that they want todistribute to their shareholders, the company’s board of directors“declare” a dividend, and the company will announce the amount andthe date that the regular dividends will be paid out during earnings calls orpress releases. Companies usually set a dividend policy to pay out their cashover time. Apart from regular dividends, companies can also pay out specialdividends, which are usually a one-time payment.

As they are paid out from the company’s profits orearnings, ordinary dividends have differentdividend tax rates than qualified dividends. These dividends are taxed asinvestment income at the ordinary income tax rate and not at capitalgains, which are the profits earned when you purchase an investment at a lowerprice than you sell.

Regulardividends as investment strategy

In the low-return world today, investors have been hungryfor investments that can give them a steady or growing cashflow. High regulardividend-paying stocks, in addition to fixed income, are important additions toa well-balancedportfolio. Apart from the traditional high yielding stocks in the utilities,telecoms, or consumer staples sector, you can spot higher dividend-payingstocks in the technology and financial sectors as well as real estateinvestment trusts and master limited partnerships. Not all dividends arecreated equal, and preferably, you want to find investments that will pay out qualified dividends, whichwill enjoy a lower dividend tax rate.

Requirementsfor Qualified Dividends

To be classified as qualified dividends and be taxed at a lower dividendtax rate, they must satisfycertain requirements:

• Paid bydomestic corporations or qualified foreign companies that trade on the U.S.stock exchanges or are incorporated in a U.S. possession.
• Must beordinary dividends and are not capital gains distributions or dividends fromtax-exempt entities.
• Met the minimumholding period requirement: more than 60 days during the 121-day periodstarting 60 days prior to the ex-dividend date for common stocks and more than90 days during the 181-day period starting 90 days before the ex-dividend datefor preferred stocks.

Ordinaryvs. Qualified Dividends

If the above criteria are not met, then the dividendsbecome unqualified, and unqualified dividends are taxed at the higher ordinaryincome tax rate rather than the lower dividend tax rate for qualified dividends.

QualifiedDividend Tax Rate

The IRS classifies capitalgains into short-term for assets that are held less than one yearand long term for assets that are held over a year. Given the different holdingperiods, short-term capital gains are treated as ordinary income while longterm gains are taxed at a lower preferential rate.

Qualified dividends and sale ofcertain assets that are held over a year qualify for long term capital gainstax rate and are taxed at 0%, 15%, or 20% based on your income bracket andfiling status. If your income is below the threshold for taxes, you pay zero.Tax-efficient strategies when selling securities can also be used to optimize taxes.

This tax rule does not apply to assets such ascollectibles, art, precious metals, jewelry, antiques, and other items. Theyare taxed at the ordinary income tax rate depending on your tax bracket,subject to a cap of 28%. The other exception is real estate and deduction.Investors can deduct depreciation on their property from their taxes over time,thus reducing the home purchase price. When the property is sold, thatdepreciated amount is treated as recapture and will be taxed at 25% while therest of the gain will be taxed at 0%, 15%, or 20%.

CapitalGains Tax Calculations

There are four steps to calculate your capital gains taxes:

1. Pick out the investments and positions that have capital gains or losses.
2. Determinewhether the gains and losses are short-term or long-term.
3. Come up witha net gain or loss for short-term and long-term. Calculate the overall netfigure if you have a gain in one and a loss in the other. If both categoriesare gains, keep them separate.
4. Apply theappropriate tax rate including the net investment income tax rate to the final results.

Certain net investment income of individuals, estates,and trusts with income above the legal threshold willincur the Net Investment Income Tax rate of 3.8%.

UnqualifiedDividends

Dividendsthat do not qualify as qualified dividends include the following:

• Real estate investment trusts
• Master limited partnerships
• Dividends paid on employee stock options orsavings or money market accounts
• Dividends paid by tax-exempt organizations

Unqualified dividends are taxed at the ordinary incomerate for your tax bracket and are higher than the dividend tax rate for qualified dividends.

TaxBrackets and Tax Rates

The U.S. tax system is a progressive one, and the IRS adjuststhe tax brackets for each filing category by inflation each year. The adjustedgross income (AGI) taxbrackets and various tax rates for 2019 including qualifieddividends tax rate are as follows:

ReportingDividends

All dividend income, whether qualified dividends or not, is taxable and needsto be reported on your tax return. Your stockbrokers will send you the year-end 1099-DIV, if you have dividendstotaling $10 or more from any entity, specifying which dividends belong toordinary or qualified. If you have an ownership in a partnership or Scorporation, dividends will be reported on your Schedule K1.

ReducingTaxes on Qualified Dividends

There are many ways to reduce your taxes for qualified dividends and otherlong-term investments. Some of the strategies involve financial planning andtiming, where possible. Seek the assistance of tax professionals to help inmaximizing tax benefits and clarifying IRS rules. Here are some examples ofways to help minimize taxes:

1. Take the time to plan the sale of your investment well as you do not need to incur taxes until you sell.
2. Try to retain your investments for over a year unless the fundamentals for that investment have clearly deteriorated.
3. Be aware of dividends that do not qualify and of your qualified dividends tax rate bracket.
4. Offset your capital losses against gains before year-end which is also known as tax loss harvesting.
5. Consider your taxable income level before you sell any winning investments so that you can enjoy the lowest tax rates possible.
6. Put your investments in tax-deferred investment accounts such as IRAs and 401(k) plans and in tax-free accounts such as a Roth IRA or Roth 401 (k).

Built-intax efficiency with M1

M1 maximizes the wealth-building potential of your dividendsby allowing you to reinvest automatically, so cash always goes to work ratherthan sitting idly in your account. The platform provides winning investmenttools that enable your money to grow automatically while minimizing your taxburden, which includes optimizing your qualified dividends tax rate.

Save more with M1. The free automated brokerage platform wascreated to make investing more accessible, convenient, and personalizedfor you. Transfer stocks and your IRA accounts seamlessly to M1 at nocosts. With no commissions or management fees, you never have to worry abouthidden fees eating into your returns again

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Tax and Legal Advice Disclaimer. M1 Finance and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice.