Although most dividends paid by corporations or mutual funds to shareholders are considered ordinary dividends, some may be considered eligible dividends. In these cases, your dividend income is subject to the capital gains tax rate rather than your higher income tax rate. Qualified dividends are thus included in the adjusted gross income of a taxpayer; however, these are taxed at a lower rate than ordinary dividends.
Key points to remember
- All dividends paid to shareholders must be included in their gross income, but eligible dividends will receive more favorable tax treatment.
- An eligible dividend is taxed at the capital gains tax rate, while ordinary dividends are taxed at the standard federal income tax rate.
- Eligible dividends must meet special requirements put in place by the IRS.
- The maximum tax rate for qualified dividends is 20%; for ordinary dividends for calendar year 2020, it is 37%.
Ordinary dividends versus qualified dividends
Qualified and unqualified dividends may have seemingly minor differences, but they have a significant impact on overall returns. Overall, most regular dividends distributed by corporations in the United States qualify. The biggest difference between qualified and unqualified dividends in terms of their impact at the time of taxation is the rate at which those dividends are taxed. Ineligible dividends are taxed at an individual’s normal tax rate, as opposed to the prime rate for eligible dividends as noted above. This means that individuals occupying any tax bracket will see a difference in their tax rates depending on whether they have qualified or ordinary dividends.
To be considered an eligible dividend, a dividend must be paid by a U.S. corporation or an eligible foreign entity. In addition, you must have held the shares for which the dividend has been paid for at least 60 days during the 121-day period that ends 60 days before the ex-dividend date. If the ex-dividend date is December 1, for example, you must have held the stock for at least 60 days during the period between June 3 and October 2.
Watch Now: What Are Eligible Dividends?
Taxation and dividends
According to the Internal Revenue Service (IRS), ordinary dividends are paid from the profits of a corporation or mutual fund and taxed at the same rate as ordinary income.These payments are shown in Box 1a of Form 1099-DIV, which is sent to investors.
Qualified dividends are similar to ordinary dividends but are subject to the same 0%, 15% or 20% rates that apply to long-term capital gains. Your eligible dividends will appear in box 1b of Form 1099-DIV.The maximum rates are:
- 0% if your ordinary income is taxed at 10% or 15%
- 15% if you are taxed at a rate greater than 15% but less than 37%
- 20% if your ordinary income is taxed at 37%
To meet the requirements of an eligible dividend, the dividend must have been paid by a U.S. corporation or an eligible foreign corporation and meet the hold period, which is more than 60 days within a 121-day period, which begins 60 days before the ex-dividend date. The holding period is different for preferred shares.
ABC Company declares dividends of 25 cents per share. If an investor owns 10,000 common shares of ABC Corporation, the dividend payment received is $ 2,500. If the ex-dividend date is July 1, the investor must have held the stock for more than 60 days from May 2 to October 30, or the 121-day period, for the payment to be considered an eligible dividend.