The vast majority of dividends are considered ordinary dividends, but some are qualified dividends and the tax treatment is different for each.
While sorting out which type of dividend you have can be confusing, it’s important to know the difference as they are taxed at different rates: Qualified dividends are taxed at the preferential capital gains rate, while ordinary dividends are taxed as income.
How Are Dividends Paid?
Typically, dividends are paid in cash, and they’re sent by the company directly to your brokerage, which will deposit the money into your account. Or many companies mail checks directly to investors who own shares in their firms.
Alternatively, you might get dividends as additional shares of stock. Some companies and mutual funds offer the option of a dividend reinvestment plan (DRIP) that will automatically buy additional shares with your dividend payment. This has the advantage of both simplifying the process (since you won’t have to receive the cash and then buy more shares yourself), and potentially being less expensive, since many DRIP programs don’t charge commissions.
Additionally, some DRIP programs offer the ability to buy additional shares at a discount.
Less commonly, a company might award a property dividend instead of cash or stock payouts. This could include company products, shares of a subsidiary company or physical assets the company owns.
Recommended: Capital Gains Tax Guide
What Is a Qualified Dividend?
Certain dividends from holding shares of stock in domestic companies and some foreign companies — and which an investor has held for a minimum period of time — are qualified dividends.
Qualified dividends are taxed at a lower rate than ordinary dividends. They’re taxed at the long-term capital gains rate, which ranges from 0% to 20%. Most people won’t pay more than 15% on qualified dividends. As such, investors typically prefer to receive qualified dividends, but they’re the less common kind of dividend paid out.
Qualified dividends must meet certain requirements:
• The dividend must be paid by a U.S. company or a qualified foreign corporation.
• The dividend must not be of the type that does not qualify.
• If you hold common stock, you must have held the shares for more than 60 days during the 121-day period starting 60 days before the ex-dividend date. (That’s the date by which an investor must have purchased shares of a stock in order to receive an upcoming dividend.)
• If you hold preferred stock, you must have held the shares for more than 90 days during the 181-day period starting 90 days before the ex-dividend date.
• A mutual fund must have held the investment unhedged for more than 60 days during the 121-day period starting 60 days before the ex-dividend date, and investors must have held their shares of the mutual fund for the same period.
How to Figure Out If You Have a Qualified Dividend
For investors about to count the number of days they’ve held a stock, be sure to include the day they sold the stock, but do not include the day they bought it.
Here is an example:
Imagine you bought 1,000 shares of ABC Company common stock on July 2, 2021, and you sold the 1,000 shares on August 11, 2021. ABC Company paid a cash dividend of 25 cents per share with an ex-dividend date of July 15, 2021.
Your Form 1099-DIV from the company shows $250 in box 1a (ordinary dividends) and in box 1b (qualified dividends). However, you only held shares of ABC Company for 40 days of the 121-day period that began 60 days before the ex-dividend date, so you have no qualified dividends from ABC Company.
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What Is an Ordinary Dividend?
Once you understand qualified dividends, it’s easy to spot the difference between ordinary dividend vs. qualified dividend: Any dividend that isn’t a qualified dividend is considered an ordinary dividend — and that’s most of them.
In general, investors should assume that any dividend they receive is an ordinary dividend unless they’re told otherwise. The payer of the dividend is required to identify the type of dividend when they report them on Form 1099-DIV at tax time. (Qualified dividends are reported in box 1b on IRS Form 1099-DIV, while ordinary dividends are reported in box 1a.)
Certain kinds of dividends are not qualified dividends even if they’re reported in box 1b of your Form 1099-DIV, according to the IRS. The following dividends are on this list:
• Capital gains distributions
• Dividends paid on deposits with mutual savings banks, cooperative banks, credit unions, U.S. building and loan associations, U.S. savings and loan associations, federal savings and loan associations, and similar financial institutions
• Dividends from a corporation that is a tax-exempt organization or farmer’s cooperative during the corporation’s tax year in which the dividends were paid or during the corporation’s previous tax year
• Dividends paid by a corporation on employer securities held on the date of record by an employee stock ownership plan (ESOP) maintained by that corporation
• Dividends on any share of stock to the extent you are obligated (whether under a short sale or otherwise) to make related payments for positions in substantially similar or related property
• Payments in lieu of dividends, but only if you know or have reason to know the payments are not qualified dividends
• Payments shown on Form 1099-DIV, box 1b, from a foreign corporation to the extent you know or have reason to know the payments are not qualified dividends
Ordinary dividends must be reported on IRS Form 1040, line 3b, and they are taxed at ordinary income rates, which range from 10% to 37%.
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How Qualified and Ordinary Dividends are Reported at Tax Time
Generally, an investor will receive a Form 1099-DIV — “Dividends and Distributions” — from each institution or company that pays a dividend of $10 or more. This form reports your capital gains distributions, dividend and non-dividend distributions, and any taxes withheld from your payments during that tax year.
Even if an investor does not receive a 1099-DIV from a company, they are still required to report any dividends on their tax return.
On Form 1099-DIV, dividends are reported as follows:
• Box 1a: Ordinary dividends, representing the total dividends paid to you during that tax year
• Box 1b: Qualified dividends, and this will be the portion of total dividends that qualify for the lower tax rate
• Box 3: Non-dividend distributions, which are a nontaxable return of capital
If you have had taxes withheld from your dividends, this will be reported in box 4.7.
The Takeaway
Understanding qualified versus ordinary dividends can help investors make decisions about what account to hold their dividend-paying investments in: Inside a retirement account, such as an IRA, an investor will owe no taxes on dividend income, but they’ll often pay ordinary income taxes on all withdrawals.
Outside a retirement account, an investor will pay lower rates on qualified dividends, and may be able to use dividends to supplement other income or to reinvest in their portfolio.
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