What is the difference between qualified and non qualified dividends

There are two types of dividends, ordinary and qualified. Ordinary dividends are taxed at the income tax rate and qualified dividends are taxed at a special lower rate.

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What Makes A Dividend Qualified?

To qualify as a qualified dividend, a dividend must meet certain requirements set forth by the Internal Revenue Service. A U.S. company or qualifying foreign company must have paid the dividend, and it must not be listed with the IRS as dividends that do not qualify. Additionally, the required minimum dividend holding period must be met. It's usually 61 days for common stock and 91 days for preferred stock.

Tip: Qualified dividends are taxed at the lower capital gains tax rate, while ordinary dividends are taxed at the higher income tax rate.

For dividends to be considered qualified, foreign companies must meet one of three requirements. They must be:

1. Incorporated in U.S.
2. Eligible for the benefits of a comprehensive income tax treaty with the U.S.
3. Readily tradable on an established U.S. securities exchange.

Which Dividends Do Not Qualify?

Some dividends are automatically excluded from being considered qualified dividends. These dividends include those paid by real estate investment trusts and master limited partnerships (MLPs). Excluded dividends also include those made on employee stock options and on tax-exempt companies.

Additionally, dividends that are paid from money market accounts or other financial institutions are reported as interest income and not qualified dividends. Special one-time dividends also aren't categorized as qualified dividends. Finally, qualified dividends must be paid for shares that aren't being used for hedging, like those that are sold short and call and put options.

How Are Qualified Dividends Taxed?

The dividend tax rate on qualified dividends is the capital gains tax rate, which ranges from 0% to 20%, depending on what tax bracket the investor is in.

Ordinary dividends are taxed at the investor's income tax rate, which will depend on what tax bracket they are in. As of 2020, the income tax brackets range from 10% to 37%. These rates can change from year to year and are listed in the instructions for each year's income tax form.

When buying dividend stocks, it's important to think about how they will be taxed because the tax rate can make a material difference in how much tax is charged.

Ordinary vs. Qualified Dividends

Tax Rate

The biggest difference between ordinary vs. qualified dividends is the tax rate. Qualified dividends are taxed at the lower capital gains tax rate while ordinary dividends are taxed at the higher income tax rate. Both dividend types are charged based on what tax bracket the investor is in.

As of the 2020 tax year, the tax rate on qualified dividends is 0%, 15% or 20%, depending on what tax bracket the investor is in. However, ordinary dividends are taxed at the investor's income tax rate depending on what bracket they are in, which can range from 10% to 37% as of 2020.

Qualified Dividend Requirements

The other difference between these two dividend types is that dividends must meet certain requirements to be considered qualified.

Qualified dividends are:

• Paid by a U.S. or qualified foreign company, not listed by the IRS as dividends that do not qualify
• Are held for a specified minimum timeframe, usually 61 days for common stock and 91 days for preferred.

Pro & Con of Qualified Dividend

• Advantage: the lower tax rate. The difference between the long-term capital gains tax rate and the income tax rate can be significant, although both depend on which tax bracket the investor is in.
• Disadvantage: you must hold them for a specific amount of time in order for them to qualify for the lower tax rate. It can be a bit confusing for beginner investors to figure out when they must own the shares for their dividend to qualify as a qualified dividend.

Qualified Dividend Holding Period

The minimum holding period for qualified dividends is usually 61 days for common stock and 91 days for preferred stock. All shares must be held unhedged, which means they aren't hedged with options.

In the case of shares owned through a mutual fund, there is an additional requirement.

1. The fund must have held the common stock unhedged for at least 61 days of the 121 days that start 60 days before the ex-dividend date. Certain preferred stock must be held for at least 91 days of the 181 days that start 90 days before the ex-dividend date.
2. Investors must hold the applicable shares of the fund for at least 61 days of the 121 days that start 60 days before the fund's ex-dividend date.

Key Takeaway: For dividends to be qualified, investors must hold the company's stock for more than 60 days for common stock and more than 91 days for preferred stock.

Qualified Dividend Example

Since the holding period can be a bit difficult to follow, here's an example of how a qualified dividend works. An investor buys 10,000 shares of a company on April 27 and then sells 2,000 of those shares on June 15. All shares are held unhedged at all times during the period. The ex-dividend date for the company was May 2.

That means during the 121 days, the investor held 2,000 shares for 49 days between April 28 and June 15 and 8,000 shares for more than 60 days between April 28 and July 1. The dividend income for the 8,000 shares would be considered qualified dividends, but the dividends paid on the other 2,000 shares would be taxed as ordinary dividends based on the income tax rate.

To determine the amount of the qualified dividend in this example, you would multiply the number of qualified shares by the amount of the dividend per share. If the dividend is 10 cents per share, the amount of the qualified dividend payment would be $800, while the amount of the ordinary dividend is $200.

Bottom Line

Qualified dividends are those that meet certain requirements. They must be from a U.S. or qualified foreign company, and the company type can't be on the IRS' list of company types excluded from qualified dividends.

Investors must also meet the required minimum holding period, which is usually 61 days for common stock and 91 days for preferred stock. The 61-day holding period must be in the 121-day window that starts 60 days before the ex-dividend date for common stock, while the 91-day holding period for preferred stock must fall within the 181 days that start 90 days before the ex-dividend date.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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