Difference between ordinary dividends and qualified dividends

What are Qualified Dividends?

A dividend is classified as qualified if it meets the following three criteria. A dividend that qualifies under these criteria is stated as such on the Form 1099-DIV, which is issued to shareholders following the end of each calendar year.

Holding Period

The dividend recipient must have had ownership of the stock for a period of greater than 60 days during the 121-day period that begins 60 days prior to the ex-dividend date. The ex-dividend date is defined as the first date immediately following the declaration of a dividend by a company's board of directors, when the purchaser of an entity's stock is not entitled to receive the next dividend payment.

Payer

The entity paying the dividend must be either a United States corporation, or a foreign corporation whose country qualifies under a tax treaty with the United States, or a foreign corporation whose stock is readily traded on an established stock exchange within the United States.

IRS Restrictions

The IRS specifically does not allow certain types of dividends from being classified as qualified dividends, such as dividends from tax-exempt organizations and capital gain distributions.

What are Ordinary Dividends?

Ordinary dividends are that portion of a company's retained earnings that are distributed to shareholders on a regular basis. These dividends are classified as ordinary income, so ordinary income tax rates apply to them. Most dividends are considered to be ordinary dividends, and so are taxed at the higher ordinary income tax rate.

Comparing Qualified and Ordinary Dividends

Dividends are taxed in different ways, depending on their classification as either qualified or ordinary dividends. In essence, qualified dividends are taxed at a lower rate than ordinary dividends. The tax rate for ordinary dividends is the ordinary tax rate, which can be twice as high as the tax rate for qualified dividends (depending on the applicable tax bracket). The tax on qualified dividends has ranged in recent years from 0% to 15%, depending on the recipient's tax bracket. A 20% tax applies to those with high incomes. The significant tax difference between these two types of dividends should drive investors to hold their dividend-paying stock for longer periods of time, thereby allowing them to retain a significantly larger proportion of their dividend receipts.

At some point in almost every investor's life, they'll be alerted to the fact that they're collecting "qualified dividends." That inevitably prompts the natural question:

What are qualified dividends?

Ultimately, the importance of this distinction has to do with how you're taxed on your dividends. The tax rate on qualified dividends is 15% for most taxpayers. (It's zero for single taxpayers with incomes under $40,000 and 20% for single taxpayers with incomes over $441,451.) However, "ordinary dividends" (or "nonqualified dividends") are taxed at your normal marginal tax rate.

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But on a more fundamental level: What exactly is a qualified dividend, and how do we know if the dividends paid by the stocks in our portfolios are qualified? And what investments pay out nonqualified dividends?

Let's start by examining how qualified dividends were created in the first place. Then we'll explain how that affects the rules governing them and ordinary dividends today.

How Qualified Dividends Came To Be

The concept of qualified dividends began with the 2003 tax cuts signed into law by George W. Bush. Previously, all dividends were taxed at the taxpayer's normal marginal rate.

The lower qualified rate was designed to fix one of the great unintended consequences of the U.S. tax code. By taxing dividends at a higher rate, the IRS was incentivizing companies not to pay them. Instead, it incentivized them to do stock buybacks (which were untaxed) or simply hoard the cash.

By creating the lower qualified dividend tax rate that was equal to the long-term capital gains tax rate, the tax code instead incentivized companies to reward their long-term shareholders with higher dividends. It also incentivized investors to hold their stocks for longer to collect them.

The idea was to create a better kind of company and a better kind of investor.

It's debatable as to whether the lower rate had the desired effect; in the 17 years that have passed, companies (particularly in the tech sector) continue to hoard a lot of cash, and buybacks were credited with being one of the biggest drivers of the 2009-20 bull market.

But it's certainly true that dividends became more of a focus for both investors and the companies paying them following the 2003 tax reforms. Even tech darlings like Apple (AAPL (opens in new tab)) and Nvidia (NVDA (opens in new tab)) regularly pay dividends.

Qualified Dividends

To be qualified, a dividend must be paid by a U.S. company or a foreign company that trades in the U.S. or has a tax treaty with the U.S. That part is simple enough to understand.

The next requirement gets tricky.

The tax cut was designed to reward patient, long-term shareholders. So, to qualify, you must hold the shares for more than 60 days during the 121-day period that starts 60 days before the ex-dividend date.

If that makes your head spin, just think of it like this: If you've held the stock for a few months, you're likely getting the qualified rate. If you haven't, you're probably not, or at least not yet.

Ordinary Dividends

Certain types of stocks don't make the cut.

For example, real estate investment trusts (REITs) and master limited partnerships (MLPs) typically do not pay qualified dividends. REIT dividends and MLP distributions have more complicated tax rules; however, in some cases, they might actually have lower effective tax rates.

Money market funds and other "bond like" instruments generally pay ordinary dividends. So do dividends paid out via an employee stock-option plan.

The good news: It's actually not your problem to figure this out if you really don't want to. Your broker will specify whether the dividends you received are qualified or not in the 1099-Div they send you at tax season.

But knowing whether you're being paid qualified dividends can help you plan properly. Perhaps you can arrange your dividend stock portfolio such that your lower-taxed qualified dividends are paid into your taxable brokerage account and your higher-taxed ordinary dividends are paid into your IRA.

If all of this is making your head spin, we can summarize like this:

Most "normal" company stocks you've held for at least two months will have their dividends qualified. Many unorthodox stocks – such as REITs and MLPs – and stocks held for less than two months generally will not.

Also, while we summarized the tax basics above, here's a look at how qualified dividends are taxed for every situation for the 2020 tax year:

How do you know if a dividend is ordinary or qualified?

Why are my dividends both ordinary and qualified?

Are qualified dividends better than ordinary dividends?

Do I subtract qualified dividends from ordinary dividends?