Published on October 19th, 2021 by Josh Arnold
We believe the best way to build wealth over the long-term is to invest in high-quality dividend stocks such as the Dividend Aristocrats, and reinvest dividends over time.
You can download an Excel spreadsheet of all 65 Dividend Aristocrats (with metrics that matter such as dividend yields and price-to-earnings ratios) by clicking the link below:
However, even with that being the case, there are different kinds of dividends that investors should be aware of, which creates different tax implications for investors.
In this article, we’ll take a look at the differences between qualified and ordinary dividends.
First, What is a Dividend?
Let’s start with what a dividend actually is, and where investors can find them. A dividend is generally a cash payout that is received by shareholders from an entity that is returning excess capital to its owners.
Dividends are typically funded out of an entity’s earnings (or earnings equivalent), and represent part of the total return for investors holding the security.
Dividends can come from a variety of stocks, including foreign corporations, Real Estate Investment Trusts (REITs), Master Limited Partnerships (MLPs), as well as any number of stocks that can be purchased on standard exchanges.
Depending upon the tax situation of each individual investor, as well as the goals of that investor come tax time, different dividend-paying securities could be better suited than others.
This, among other reasons, is why it is important for investors not to simply chase the highest dividend yields, but rather to be thoughtful about which dividends are best.
Different Kinds of Dividends
Dividends received by investors come in two different forms: ordinary and qualified. The difference is largely how they are treated for tax purposes. When an investor’s total income and resulting tax situation is considered, ordinary dividends could be more burdensome than qualified dividends.
Prior to 2003, all dividends were taxed as ordinary dividends, because qualified dividends didn’t exist until tax changes enacted in 2003 were put into place. The idea was to encourage companies to pay dividends to shareholders by making it more tax-advantaged for investors, and qualified dividends were born.
Ordinary dividends are taxed as regular income, meaning it is taxed in the same way that income from traditional employment would be taxed. The result of that is the investor must pay their standard tax rate on any ordinary dividends.
Conversely, qualified dividends are taxed at capital gains rates, which are generally lower than that of regular rates. In fact, for low-income recipients of qualified dividends, there could be no tax bill at all. Most dividends paid buy US corporations to US-based taxpayers can be classified as qualified, but there are some caveats.
One caveat is that dividends received from a money market fund and REITs are generally classified as ordinary, irrespective of the other criteria that must be met for qualified dividends. Apart from that, there are some general conditions that must be met for qualified dividends.
To qualify, dividends must meet a minimum holding period, must have been paid by a US company or a qualifying foreign company, and the dividend must not be listed with the IRS as those that do not qualify.
The IRS requires investors to hold shares for a minimum period in order to get the favorable tax treatment of qualified dividends. Common stock investors must hold share for more than 60 days during the 121-day period that starts 60 days before the ex-dividend date.
For preferred stock, which is a form of perpetual debt that trades on stock exchanges, the holding period is more than 90 days during a 181-day period that starts 90 days before the ex-dividend date. For mutual funds, the holding period requirement is at least 61 days of the 121-day period which begins at least 60 days before the ex-dividend date of the fund.
Qualifying foreign companies have to meet one of three specified criteria. It must be incorporated in the US, be eligible for a comprehensive income tax treaty with the US, or is readily tradable on an established exchange in the US. A foreign company that is classified as a passive foreign investment company is automatically excluded from qualified dividends, and dividends will be considered ordinary.
Certain dividends are specifically excluded from being qualified by the IRS, including REITs, MLPs, dividends on employee stock options, and those on tax-exempt companies. In addition, special one-time dividends are always taxed as ordinary income.
Qualified dividends must also come from shares that are not associated with hedging, such as those used for short sales, or call and put options.
The difference between the taxes owed on dividends can be substantial between qualified and ordinary dividends. Qualified dividends, for instance, have a top tax rate of 20%, which is the highest capital gains rate for the highest earners in the US, currently. Most taxpayers would owe 15% or less on qualified dividends, and low earners would see no federal income tax at all on their qualified dividends.
Conversely, ordinary dividends can be taxed up to 37%, which is currently the highest federal income tax rate. Taxpayers do not need to figure out if their dividends are qualified or not for tax time, given that brokers must do that for investors. However, if investors are going to receive ordinary dividends, it is best to do so in a tax-advantaged account such as a 401(k) or IRA.
Qualified and Ordinary Dividend Examples
Now that we’ve covered what criteria must be met for qualified dividends, let’s take a look at a real world example of what each kind of dividend would look like.
One example of a stock we like that pays US investors qualified dividends is AT&T (T). The company is a leader in telecommunications, has paid rising dividends for the past 36 years in a row. AT&T stock is undervalued, and pays shareholders a massive 8.2% dividend yield.
Provided shareholders meet the holding period criteria, these dividends can be received at the investor’s capital gains tax rate, which in most cases is quite low. We like AT&T for a variety of reasons, and its favorable tax treatment eligibility is just one more.
An example of a stock we like that is not eligible for qualified dividends is Omega Healthcare Investors (OHI), a REIT that is focused on skilled nursing facilities in the US. We like Omega for its 8.5% dividend yield and nearly two decades of consecutive dividend increases, as well as its exposure to the trend of an aging US demographic.
Both of these stocks offer advantages to shareholders, but all else equal, qualified dividends in taxable accounts are the best way to go.
Final Thoughts
The question of whether an investor should hold securities of companies that pay qualified dividends is an important one, particularly if the investor holds a large amount of stocks, or is in a high income tax bracket.
Generally speaking, ordinary dividends are taxed at roughly double the rates of qualified dividends, depending upon the specific tax situation, so the difference can be sizable.
