Definition
Qualified dividends are payouts received from investments in a company’s stocks or securities that are taxed at capital gains tax rates, which are typically lower than regular income rates. Ordinary dividends, on the other hand, are taxed as ordinary income at the investor’s marginal tax rate, which is generally higher. Therefore, the main difference lies in the tax treatment of these two types of dividends.
Key Takeaways
- Qualified dividends are a type of dividend that are taxed through the capital gains tax rate which is lower than the regular income tax rate, making them beneficial for investors. They must meet certain criteria established by the Internal Revenue Service.
- Ordinary dividends or non-qualified dividends do not meet the IRS standards for qualified dividends, hence, they are subject to standard federal income tax rates.
- The main difference between the two lies in the tax treatment, where qualified dividends offer more tax advantages compared to ordinary dividends. It’s important for investors to distinguish between the two to effectively manage their investment taxes.
Importance
The finance terms, Qualified and Ordinary Dividends, are important as they relate to the taxes a investor pays on their dividend income.
Qualified dividends, typically derived from shares in U.S.
companies held for a minimum specified period, are taxed at a lower rate than regular income—this is because they are taxed at the long-term capital gains rate instead of regular income tax rates.
On the other hand, Ordinary dividends, such as those derived from short-term holdings or from certain foreign companies, are taxed at the individual’s regular income tax rate.
Understanding the distinction between these two types of dividends is crucial for strategic tax planning, allowing investors to potentially enhance their post-tax return on investments.
Explanation
Qualified dividends and ordinary dividends are two forms of profit distribution corporations may give to its shareholders and they each serve different purposes. Qualified dividends are primarily used for long-term investments and they are subjected to a special tax rate based on an individual’s income, but generally lower than the tax rate on ordinary income.
Corporations distribute these types of dividends from their after-tax profits to benefit their long-term shareholders. In essence, this encourages a steady and prolonged investment mindset among their investors, thereby offering the company a certain level of financial security.
On the other hand, ordinary dividends are often employed for short-term investing strategies. They are taxed as ordinary income based on the recipient’s regular tax bracket.
Ordinary dividends are common and can be distributed more frequently, making them an attractive option for investors seeking more immediate returns on their investment. When considering investments, individuals have to understand the difference between these two types of dividends, both in how they will impact their overall portfolio growth and in how they will affect their tax situation.
Examples of Qualified vs Ordinary Dividend
Microsoft Corporation: Microsoft, a US-based multinational technology company, regularly pays dividends to its shareholders. In 2020, much of the dividends Microsoft paid to U.S. residents were considered qualified dividends, as most of them met the holding period requirements and other criteria defined by the IRS. This means that shareholders who received these dividends were eligible for the lower tax rates applicable to qualified dividends, rather than the higher tax rates for ordinary income.
Amazon: Amazon, another technology giant, had a different scenario. For a long period, Amazon did not pay dividends at all, choosing instead to reinvest its profits back into the business for rapid growth. However, if Amazon had paid dividends, and if those dividends did not meet the criteria such as the required holding period, they would be classified as ordinary dividends, subject to the recipients’ ordinary income tax rate.
General Electric: General Electric has had various episodes where it had to reduce its dividends due to financial difficulties, indicating a change in its financial stability. In these cases, if a shareholder sold their shares before meeting the holding period criteria because they were not comfortable with the company’s outlook and before a dividend was issued, then the dividend would be classified as an ordinary dividend for them, taxable at their regular income tax rate.
Qualified vs Ordinary Dividend
What is a qualified dividend?
A qualified dividend is a type of dividend that is taxed at the capital gains tax rate. Generally, any dividend that is paid by a U.S. corporation or a qualified foreign corporation is a qualified dividend as long as the investor holds the shares for a required period.
What is an ordinary dividend?
Ordinary dividends are regularly taxed as ordinary income, not at capital gains rates. They are distributions of property a corporation may pay you if you own stock in that corporation.
What are the tax implications of qualified dividends vs. ordinary dividends?
Qualified dividends are taxed at a lower rate than the rate for ordinary income. The tax rate on qualified dividends as per the current law is 0%, 15%, or 20%, depending on the taxable income. Ordinary dividends, on the other hand, are taxed as ordinary income.
How can I tell if a dividend is qualified?
Typically, you will find information about the type of dividend you received in box 1b of the Form 1099-DIV you receive from the payer of the dividend. The total amount of qualified dividends will be reported in box 1b.
Can an ordinary dividend become a qualified dividend?
Yes, an ordinary dividend can become a qualified dividend if the dividend is paid by a U.S. corporation or a qualified foreign corporation, and if the investor holds the shares for a specific period of time.
Related Entrepreneurship Terms
- Dividend Tax Rate
- Capital Gains
- Holding Period
- Preferred Stock
- Cost Basis
Sources for More Information
- Internal Revenue Service (IRS): The U.S. government agency responsible for tax collection and tax law enforcement. Information regarding qualified and ordinary dividends can be found in their resources on investment taxation.
- Investopedia: A comprehensive financial website with a host of information about various investments, including an explanation between the differences of qualified and ordinary dividends.
- Fidelity Investments: An American multinational financial services corporation. It provides investment advice including the differences between qualified and ordinary dividends.
- Charles Schwab: A bank and stock brokerage firm in the United States. It also has detailed information about qualified and ordinary dividends within its numerous financial resources.
