What is a Qualified Dividend?

A qualified dividend refers to a dividend covered under capital gains tax rates that are less as compared to the income tax rates on dividends. In order to be eligible for the highest tax rates of 0%, 15%, or 20% that are applicable for capital gains in the long run, qualified dividends must comply with the following criteria as stated by the Internal Revenue Service (IRS).

1. A U.S. firm or an organization that is qualified should pay the dividend.
2. The dividends that are not mentioned in the IRS are not eligible.
3. The specified timeline of holding dividend is fulfilled.

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How Does a Qualified Dividend Work?

Dividends can be broadly divided into two categories: qualified or ordinary. These two types have varied tax implications affecting the net return of investors. Investors who have their ordinary income taxed at 10% or 15% pay zero taxes on qualified dividends. However, the ones who pay income tax between 15% and 39.6% pay 15% tax rate for qualified dividends. Persons falling in the tax category of 39.6% receive a capping of 20% on qualified dividends. Also, married individuals having modified adjusted gross income of more than $200,000 or $250,000 and filing taxes in a joint manner incur Net Investment Income Tax of 3.8%. IRS Form 1099-DIVs box 1b enlists qualified dividends. Investors who receive dividends or returns on investments, irrespective of the nature, during the financial year receive this tax form. Box 1a covers ordinary dividends that are said to be the most ordinary types of dividend offered to investors from a mutual fund.

Qualified vs Unqualified

Though qualified and unqualified dividends have very less differences, but they tend to have a big effect on the total returns of an investor. Usually, regular dividends offered by the U.S. companies are qualified. Both of these dividends vary in terms of tax rates. While unqualified dividends get taxed at usual income tax rate of a person, qualified dividends get taxed at preferred rates as mentioned above. Hence, individuals falling in any tax bracket will encounter a variation in their tax rates based on the nature of dividends, qualified or ordinary.

More on Qualified Dividend Requirements

A foreign company that fulfills any of these three requirements can be eligible for special tax rates: the organization incorporates in a U.S. possession, the organization qualifies for the advantages of a comprehensive income tax treaty with the U.S. or the securities can be traded immediately on an approved securities market in the U.S. In case, a foreign firm is considered to be a passive foreign investment firm, it doesn't become qualified.

Dividends that Don't Qualify

There are some dividends such as dividends offered by real estate investment trusts, master limited partnerships, dividends received on employee stock options, dividends from tax-exempt firms, etc. that don't qualify for being called as qualified dividends. Dividends that are offered from money market accounts like deposits in credit unions or banks are not qualified, and should be recorded in the interest income category. Special one-time dividends also fall under the unqualified category. Also, qualified dividends should be a result of shares that don't involve hedging like the ones considered for short sales, call options, etc. The above mentioned investments belong to the ordinary income tax rate.

The Holding Period

In order to enjoy low tax rates on qualified dividends, the IRS asks investors to hold shares for a specific time period. For common stock investors, this time should be more than 60 days during the time period of 121 days that commences 60 days prior to the ex-dividend date, or the time post the payment of dividend, and after which new investors would be qualified for getting prospective dividends. Considering the preferred stock, the holding period is above 90 days during a time period of 181 days that commences prior to the ex-dividend date. The holding period conditions for mutual funds are somehow different. They should hold the security unhedged for a minimum of 61 days of the time period of 121 days which commences at least 60 days prior to the security's ex-dividend rate. Investors should also hold the said share of the mutual fund for the similar time duration.

Holding Period Example

It can be hard to identify the conditions of a holding period. Lets consider this random example: An investor gets qualified dividends from shares invested in a mutual fund named X. He purchased 1000 shares of mutual fund X on 1 May for the given tax year. Then he held 900 shares, and sold the remaining 100 shares on June 1. Hence, the ex-dividend date for the mutual fund was May 15. In the time period of 121 days, the investor kept 100 shares from May 1 to June 1 for 31 days, and the remaining 900 shares for a minimum of 61 days, i.e. from May 1 to July 1. This means the dividend income (received from 900 shares) that was held by the investor for at least 61 days would be considered as qualified income, while the income secured from holding 100 shares for 31 days would be considered as unqualified dividend income. Hence, the investor can ascertain the amount of actual qualified dividend by using the qualified dividend for each share for filing tax.

What it Means for Investors

Whether a dividend will fall under qualified or non-qualified category doesn't prove to be an issue for investors. This is so because the most regular dividends offered by the U.S. firms come under the qualified category. Investors who invest in foreign firms, real estate investment trusts, MLPs emphasize on the difference between qualification and the alternative for the purpose of tax calculations. Investors don't have the authority to determine whether a dividend will be qualified or not. However, they can hold securities for at least the time period as per the stock type.