What is a qualified dividend : Understanding of Ordinary Dividends vs Qualified Dividends

Tue, May 21, 2013

 

Qualified Dividend Income Tax Rate

Many investors have come to relish the regular income and increased returns which dividend investing strategies offer.qualified dividends rate

But there is one major downside to dividend investing. And that’s taxes.

Dividends are treated as taxable income. As a result, high-income earners could end up paying as much as half of the dividends payments to the government in taxes.

But not all income investors get hit equally as hard when it comes to taxes on dividends. In fact, there’s a special type of dividend which receives favorable tax treatment. And by focusing on these special dividend investments, you can go a long way to reducing your tax bill and increasing your net after-tax returns.

Here’s how.

Defining a Qualified Dividend

The special type of dividend is called a “qualified dividend.”

Now, a qualified dividend isn’t much different than any other regular dividend from an investment.

There’s just one slight difference which could mean the difference between paying 43% in taxes on it or 15%.

Let’s start with an example where an investor in shares of Verizon (NYSE:VZ), an attractive and consistent dividend-paying stock, receives regular dividends every three months.

The dividends are paid by the company to shareholders. The cash dividend payment comes from the excess cash flow Verizon earns from customers to its mobile, cable, and Internet customers.

qualified dividend income

What makes these dividends specifically qualified dividends instead of ordinary actually has nothing to do with the company paying them, when they pay them, or how much they are.

The main difference between an ordinary dividend and a qualified dividend is determined in the U.S. Tax Code.

IRS Publication 550: Investment Income and Expenses states:

[A qualified dividend comes from a stock that] must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.

That rule means the difference between ordinary dividends (which are taxed at the regular income tax rate) and qualified dividends (which are taxed at a lower preferred rate) are determined merely by how long and investor has held the stock.

Under the current law, a stock must be held 60 days before the ex-dividend date (that’s the date you must hold shares to receive the dividend payment which often comes a few weeks later on the dividend payment date).

So for long-term investors looking to hold all of their investments at least one year, the first dividend payment they receive would likely be classified as an ordinary dividend. But all the ones that come after that would be qualified dividends and receive the lower tax treatment.

Why Are There Ordinary and Qualified Dividends?

The “Qualified Dividend “rule was put into place to reward long-term investors.

It’s similar to the long-term capital gains tax rates on assets held more than one year.

The goal is to encourage long-term investment and saving.

Dividend investors using these rules to their advantage will go a long way to helping them to help reach their investment goals. After all, any increase in net after-tax returns will mean more money in your portfolio at the end of the year. And it means more money to reinvest in the many investment opportunities which are opened up each year.

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