Qualified Dividends vs. Non-Qualified Dividends
March 7, 2017
Qualified vs. Non-Qualified Dividends
There are a few things that every income-oriented investor considers when researching stocks, such as an understanding of the business model, future growth prospects, the current dividend yield, and the history of the dividend payment.
However, there is one important factor that is often forgotten, despite being as important as the others: how the dividend will be taxed.
This would not be a big deal if all dividend companies were put in the same category. However, this is not the case, because all dividend stocks fit into one of two: qualified or non-qualified dividends.
Knowing the difference and how qualified dividends are treated compared to non-qualified ones could result in you saving hundreds or thousands of dollars in tax payments.
This article will go through some important questions that you may have thought about when it comes to taxes on dividends. Below are more details of the difference between qualified vs. non-qualified dividends, how dividends are taxed, dividend rules, and more.
What Are Qualified Dividends?
Besides a company paying out a dividend in the first place, it must be listed on an established U.S. trading exchange, such as the New York Stock Exchange (NYSE) or the NASDAQ, to be considered a qualified dividend.
Companies on these exchanges must also be based in the U.S. and trading as an American depositary receipt (ADR). Those dividend-paying stocks not based in the U.S. must be located in a country that has an income tax treaty with the U.S. However, note that there may be withholding tax in the country that the investment is made in.
If you indirectly own stocks that would be paying a qualified dividend, then you’re receiving what’s called qualified dividend income. Examples would include owning a hedge fund, mutual fund, or an exchange-traded fund, which has paid their unitholders with a dividend.
A lower tax rate is applied to dividend income. More information regarding the exact rates appears further below.
What Would Make a Dividend-Paying Stock a Non-Qualified Dividend Investment?
There are some investments that pay a monthly or quarterly dividend but, with the income actually being considered as non-qualified dividend income. One such type of company is real estate investment trusts (REITs). This occurs because REITs tend to not use their earnings to pay the dividend, instead opting to use the likes of capital gains, return on capital, and interest income.
Another vehicle for non-qualified investments is by going in on the preferred debt of a company. The reason this would be a non-qualified dividend is that the payment to investors is made in the form of an interest payment.
For investors using short-term products such as mutual savings banks, cooperative banks, credit unions, federal savings and loan associations, U.S. savings and loan associations, and U.S. building and loan associations, the payment is made in the form of an interest payment and not a dividend. This results in the payment being labeled as a non-qualified dividend.
If you are part of an employee stock ownership plan (ESOP), the dividends received would also be considered as non-qualifying dividends.
There is one scenario in which an investor would have to pay a dividend: when they are using a short-selling strategy. The dividend paid out due to this strategy would result in it being a non-qualified payment.
If you happen to be an investor in a tax-exempt organization or an agricultural cooperative which pays a dividend, it would also be such a payment.
Since these payments are not considered qualified dividend income, a higher tax rate is charged. More information regarding tax rates on this type of income is further below.
Can a Dividend Be Both Qualified and Non-Qualified?
There is one scenario in which a dividend would be considered both a qualified and non-qualified dividend, provided the dividend payment first meets all the rules that are applied to being a qualified dividend investment.
The one factor that will determine if the dividend is a qualified vs. a non-qualified dividend payment is the length of time the investment is held. A qualified dividend’s holding period is different when it comes to holding common and preferred stock.
If you receive a dividend from a common stock, then you must own the stock for more than 60 days, including the ex-dividend date. But, if the dividend is from a preferred stock, then you must own the shares for more than 90 days, again including the ex-dividend date.
If these time periods are met, then the dividend income would be considered qualified investments. But, should the dividend-paying stock be held for less time than listed above, then the income would be classified as non-qualified dividends.
It is an investor’s duty to track how long the shares were held. This is also an example of when being a patient investor will pay off, with a lower tax rate applied to dividend income.
Are Non-Qualified Dividends Ordinary Dividends?
Another term that is commonly used to describe non-qualified dividends is “ordinary” dividends. This is because the tax rate applied to these dividends would have the same rate as ordinary income.
Tax On Dividends
Typically, investors are concerned with two numbers: the current trading price of a stock and the dividend yield being offered. I would recommend adding one more number before considering an investment: the tax rate that will be applied to the dividend income.
Below is a table of how qualified and non-qualified dividends are taxed, regardless of marital and living status. Based on the income level, the corresponding tax rate will be applied.
How Are Qualified and Non-Qualified Dividends Taxed?
| Single Reported Taxable Income | Married Filing or Qualifying Widow(er) | Married Filing Separately | Head of Household | Tax Rate On Qualified Dividend Stocks | Tax rate On Non-Qualified Dividend Stocks |
| $0.00-$9,275 | $0.00-$18,550 | $0.00-$9,275 | $0.00-$13,250 | 0% | 10% |
| $9,276-$37,650 | $18,551-$75,300 | $9,276-$37,650 | $13,251-$50,400 | 0% | 15% |
| $37,651-$91,150 | $75,301-$151,900 | $37,651-$75,950 | $50,401-$130,150 | 15% | 25% |
| $91,151-$190,150 | $151,901-$231,450 | $75,951-$115,725 | $130,151-$210,800 | 15% | 28% |
| $190,151-$413,350 | $231,451-$413,350 | $115,726-$206,675 | $210,801-$413,350 | 15% | 33% |
| $413,351-$415,050 | $413,351-$466,950 | $206,676-$233,475 | $413,351-$441,000 | 15% | 35% |
| $415,051 or more | $466,951 or more | $233,476 or More | $441,001 or more | 20.00% | 39.60% |
How to Report Qualified Dividends
If you receive any qualified dividends, then you also need a 1099-DIV form. The total qualified dividends received throughout the year will appear in box 1B of the form, which is received through your broker.
The next step would be to be to acquire form 1040 or 1040A and complete line 9B. This will officially report the amount of qualified dividends that you have earned over the year.
How to Report Non-Qualified Dividends
If you receive any non-qualified dividends, then the amount will determine how to report this information.
If you receive more than $1,500.00 in non-qualified dividends (ordinary dividends), then steps five to nine of form 1040 or 1040A must be completed. If you obtain less than $1,500.00, then you must add the non-qualified dividends that are received to your income.
How Are Dividends Reported on Restricted Stocks?
Restricted stocks are received from an employer. The shares are non-transferable and do not have to be reported on your tax return filing as income. If the shares pay a dividend, then the income must be reported on your tax return file as wages and not as dividends. This same scenario would occur if you are an independent contractor.
Why Are Dividends Taxed Differently?
The U.S. government has put tax rules in place to favor companies based in the U.S. or that have a tax treaty with the country of operations. The government wants investors to own companies within its borders, or at least ones that has have a strong relationship with the United States. As a result, investors pay a lower tax rate on their dividend income.
Another concern the government had for investors is whether they would work to build long-term wealth or simply look to make a quick profit by being an active trader. This is why investors must own dividend-paying stocks for a certain period in order to be eligible to pay a lower tax rate.
The government is rewarding investors for taking the additional risk of investing in the stock market because there is always the option of safe investments, such as T-bills and money market products, which offer little to no risk and a guaranteed return. However, the downside is that a higher tax rate is applied to the income when going with the safe investments.
One other reason that investors see a lower tax rate is because the dividend has already been taxed once. A high tax rate would discourage companies from a paying a dividend, pushing income investors away from these types of investments.
Final Words of Advice
Paying taxes on dividend income is just one factor that should be considered before capital is deployed into an investment. Ensure that the dividend-paying stock meets your goals, whether that includes investing into dividend growth companies, high-dividend-paying companies, or ones with a steady and reliable dividend payment.
Also ensure that the risk of the investment is within your comfort level; you don’t want to lose any sleep at night thinking about the dangers associated with the investment. Most importantly, understand the investment that you are making based on the business model, and how the future of the business looks.
