Every investor hopes for a strong return on investment from their stock portfolio, but the truth is that dividends paid out from corporate stocks are not created equal. The way in which dividends are treated for tax purposes plays a central role in an investor’s ROI, making it important for would-be and current investors to have a firm understanding of the different types of dividends and the tax implications of each.
There are two types of ordinary dividends: qualified and nonqualified. The most significant difference between the two is that nonqualified dividends are taxed at ordinary income rates, while qualified dividends receive more favorable tax treatment by being taxed at capital gains rates.
What classifies a dividend as ‘qualified’ for tax purposes?
Ordinary dividends are the most common type of distribution from a corporation or a mutual fund – as they are paid out of earnings and profits. Examples of ordinary dividends that do not qualify for preferential tax treatment include:
- Generally, dividends paid out by real estate investment trusts (there are instances where dividends can be considered qualified, provided certain requirements are met – – See IRC §857(c))
- Generally, dividends paid out by master limited partnerships (However, if the MLP is invested in qualifying corporations and it receives qualified dividends from those investments, it would pass out qualified dividends to the partners)
- Dividends paid on employee stock option plans
- Dividends paid by tax-exempt companies
- Dividends paid on savings or money market accounts by mutual savings banks, mutual insurance companies, credit unions and other loan associations
Other dividends paid out by U.S. corporations are qualified. In order to meet Internal Revenue Service standards, however, the requirements listed below must be met:
- The dividends must have been paid by a U.S. corporation or a qualified foreign corporation
- Investors must adhere to a minimum holding period
There are a few details to remember when considering these two rules. First, a foreign corporation is considered “qualified” if it has some association to the U.S., typically in the way of residing in a country that has a tax agreement in place with the IRS and Treasury Department. Because other circumstances may classify a foreign corporation as “qualified,” investors who are tax planning should consult a tax or accounting professional to determine definitively how dividends paid out by a foreign corporation will be classified for tax purposes.
Special holding rule requirements apply in order for a dividend to receive favorable tax treatment. For common stock, a share must be held more than 60 days during the 121-day period beginning 60 days before the ex-dividend date. Under IRS guidelines, the ex-dividend date is the date after the dividend has been paid and processed and any new buyers would be eligible for future dividends. For preferred stock, the holding period is more than 90 days during the 181-day period beginning 90 days before the stock’s ex-dividend date.
Changes to capital gains tax rate for qualified dividends
Knowing how dividends will be taxed is of particular importance in 2013, as new capital gains rates went into effect. High-income earners with qualified dividends may find themselves paying more. As of this year, single filers earning more than $200,000 and joint filers earning more than $250,000 will be subject to the additional 3.8% Medicare surtax on investment income. In addition, single taxpayers earning more than $400,000 and joint filers earning more than $450,000 will be subject to:
- A top marginal rate of 39.6 percent, up from 35 percent in 2012
- A 20 percent tax on long-term capital gains and qualified dividends, up from 15 percent
Investors in the 25 to 35 percent bracket may see qualified dividends taxed at 15-18.8 percent, while those in the 0 to 15 percent bracket will not be subject to capital gains taxes on qualified dividends.