There is a big difference between qualified and unqualified dividends, and that difference could determine whether or not one will pay taxes on them.
There is no getting around taxes. It hits us each year and each year it is a double whammy - not only does money go away, but there is frustration in simply figuring out how much is to go away. One need to somehow find ways to make an utterly dismal task palatable.
One of the few smiles possible is that of finding that one is able to take advantage of a tax break. Tax breaks are not only for millionaires and billionaires, but can be found for the small investor. That is the case when considering qualified and unqualified dividends, and that is why we need to understand the difference between the two types.
The good news is that most stock dividends fall into the category of qualified dividends. To be classified as a qualified dividend, the IRS lists three categories, each under which the dividend must fall.
There is a list of about 75 countries with which the United States has an income tax treaty. I find it interesting that in addition to Russia being included, so it the USSR (I thought they went away in the early 1990s). It is almost certain that the company in which one is investing will be covered within this group.
This is one of those non-helpful descriptions one often gets within government documents. Generally speaking, what they are talking about are special cases, like dividends from cooperative banks and credit unions that should be reported as interest income, dividends from tax-exempt organizations, and a handful of other issues that are not common.
This is a more common situation for investors who are trading stocks more frequently than the long term investor. One must have owned the stock for a required amount of time around the ex-dividend date. In this case, the holding period starts 60 days before the ex-dividend date and ends the 60 days after. Within this 121 stretch of days, one must have owned the stock for at least 61 of those days.
As an example, one purchases shares of a company on July 5, the ex-dividend date is July 12 and the shares are sold August 8. The dividends the investor received would then not be considered qualified dividends because the shares were only owned for 34 days. If the investor had held the shares until November 1 then they would have been owned for more than 60 days within the May 13 (60 days before the ex-dividend date) – September 10 (60 days after the ex-dividend date) timeframe, thus the dividends would be considered to be qualified.
And yes, as always appears to be the case, there are exceptions to this, but they are rather uncommon.
Unqualified dividends are alternatively called common dividends. Generally speaking, these are dividends that do not fall into all of the three categories outlined above. There are some categories like REITs, employee stock options, dividends from money market accounts, and special one-time dividends that designate them in the unqualified category, but for the most part, if one is purchasing dividend stocks for the long term then almost certainly all dividends will be considered qualified.
The information for each company and mutual fund as to the total amount of dividends for the year and the amount that is qualified is listed on lines 1a and 1b on the 1099-DIV that is received at the beginning of the year.
The reason that the distinction between these two types of dividends is so important is that they are taxed differently. Nonqualified dividends are taxed at the capital gains rate. This means that there is no difference (tax-wise) between dividends that are considered nonqualified and regular income.
On the other hand, qualified dividends are taxed at a lower rate – if at all. If a single filer has a gross adjusted income under $39,375 then the dividends are tax-free. Joint filers have the amount moved up to $78,750 without having to pay taxes on those dividends.
2019 Single Filer Tax Brackets
|Income Tax Bracket||Income Tax Rate||Capital Gains Rate|
|$0 – $9,700||10%||0%|
|$9,526 – $39,375||12%||0%|
|$39,376 – $39,475||12%||15%|
|$39,476 – $84,200||22%||15%|
|$84,201 – $160,725||24%||15%|
|$160,726 – $204,100||32%||15%|
|$204,101 – $434,550||35%||15%|
|$434,551 – $510,300||35%||20%|
2019 Joint Filer Tax Brackets
|Income Tax Bracket||Income Tax Rate||Capital Gains Rate|
|$0 – $19,400||10%||0%|
|$19,401 – $78,750||12%||0%|
|$78,751 – $78,950||12%||15%|
|$78,951 – $168,400||22%||15%|
|$168,401 – $321,450||24%||15%|
|$321,451 – $408,200||32%||15%|
|$408,201 – $488,850||35%||15%|
|$488,851 – $612,350||35%||20%|
The charts for the 2020 tax year are scheduled to allow for slightly higher income tax brackets, so the single filer will be able to receive up to $40,000 in dividends and joint filers will be able to receive up to $80,000 without having to pay taxes on the dividends.
As can be seen from the charts above, this makes for a very strong retirement strategy. If a single filer were to have a million dollar portfolio of dividend stocks offering an average dividend yield of 3.5%, it would result in $35,000 in dividends that would not be taxed. If the filer needed $50,000 during the year then that $15,000 of non-dividend money would be taxed at a lower rate than if the entire $50,000 came outside of dividends. Joint files would double those amounts.
It is clear that there is a huge tax advantage to ensuring that dividends are qualified. The stream of cash from qualified dividends is almost like taking money from a Roth IRA unscathed by taxes. When I start the chore of working on my taxes in March I will be grumbling until I get to the part where I report my dividends, knowing that that income will pass through without being touched by the taxman.