Qualified & Non-Qualified Dividends: How They Affect Taxes?

When it comes to finances, there are probably many things that you keep track of. However, filing taxes can be a bit of a nightmare for many people. It's not common for people to forget what they spent their money on or how much they spent. It can get even more complicated when it comes to an understanding of how taxes work with dividends and qualified dividends. 

What are qualified dividends, and do you have any of them? If so, does that mean you'll pay more taxes than expected? There are so many details that go into your taxes that it can be challenging to remember them all. Fortunately, you may learn all you need to know about the tax implications of qualified and nonqualified dividends in the following paragraphs of this article.

What Are Qualified Dividends?

Dividends are the amount a company pays out to shareholders from their profits. The dividend you receive is typically proportional to the number of shares you own. For example, suppose a company earns $5 million in profits and has 1 million shares. In that case, it will pay shareholders $5 per share in dividends. There are two types of dividends – qualified and nonqualified. 

The Dividends which qualify for lower tax rates are called "qualified" dividends. If you receive a dividend that is not qualified, you will be taxed according to regular rates. Most people receive nonqualified dividends, which are most common in the form of interest from savings accounts or bonds. Most of these are taxable but are taxed at a lower rate than ordinary income. 

Nonqualified dividends are subject to the same rates as other income but max out at a lower rate. In 2018, the 10% tax bracket ended at $19,400, so the lowest rate applied to nonqualified dividends is -12.19%. Qualified dividends, however, are subject to a different set of rules. They fall into two categories: dividends that fall under the standard rules for dividends.

Tax Basics For Dividends

All dividends are taxable, but that doesn't mean they are taxed at the same rate. When it comes to taxes, only a portion of qualified dividends is subject to the regular corporate tax rate. Here's how regular and qualified dividends are taxed: Dividends are taxed as ordinary income at rates up to 39.6%. If you invest in dividend-paying stocks through a brokerage account, you will likely have nonqualified dividends. If you own dividend-paying stocks directly (through a mutual fund, for example), you will have qualified dividends. The difference between nonqualified and qualified dividends is that qualified dividends are given preferential tax treatment. For a dividend to be qualified, the issuing company must meet specific criteria. Most commonly, this criteria has to do with the company's percentage of domestic ownership.

How Qualified Dividends Are Taxed?

If you receive a qualified dividend, you'll pay 0% tax on the first $7800 you earn (depending on the current tax rates). Then the remainder will be taxed according to the regular rates (above). For example, let's say you receive a dividend of $2000. You'll pay 0% tax on the first $7800 and then regular tax rates on the remaining $1200.

When Are Qualified Dividends Tax-free?

As we mentioned, qualified dividends are taxed differently than nonqualified dividends. However, there are situations when qualified dividends are tax-free. Here are a few examples: - If you've held the stock that paid you the dividend for at least 61 days, it's considered a long-term dividend. Long-term dividends are taxed at 0%. 

Remember that you are still required to report the dividend as income and pay taxes on it. - If you've held the stock for less than 61 days, and it is a short-term dividend, it's still taxable. However, there are certain circumstances where short-term dividends are tax-free. For example, there could be a significant change in the company's overall business, or the company could repurchase its stock.

 Dividends paid by mutual funds can be short-term, even if you've owned the fund for years. - If you received the dividend from a cooperative, it's also tax-free. This is because you are receiving a portion of the company's profits. You are also required to report the dividend as taxable income.

What are Non-qualified dividends?

Nonqualified dividends are dividends that do not qualify for the lower tax rate. Regular income tax rates apply to nonqualified dividends, which implies that they are taxed at the following rates: The 10% tax rate applies to incomes between $9,325 and $37,950 per year.

Taxpayers who are married and filing jointly or as heads of households in 2019 will be able to deduct $18,350 from their taxable income as opposed to the current standard deduction of $12,200.The 2019 Pease limitations reduce the number of deductions high-income taxpayers can claim. 

Qualified V/s Nonqualified Dividends

Nonqualified dividends have the major disadvantage of being taxed at a higher rate than qualified dividends. For the tax year 2022, nonqualified dividends are taxed at the same rate as an investor's regular income tax rate, sometimes known as your marginal tax rate.

For comparison, qualifying dividends are taxed at the long-term capital gains rate, either 0%, 15%, or 20%, depending on an investor's tax status. As a result of the distinction, investors pay significantly more in taxes on nonqualified dividends. On the other hand, dividend tax rates are generally relevant only for equities owned directly or in a taxable brokerage account. 

Employee stock options are another element that might exclude a payout from a reduced tax rate. This is because stock options are commonly used as a form of remuneration. The IRS considers the dividend paid by that option to be income, which it taxes based on the recipient's tax bracket.

The sort of firm that pays a dividend is a crucial qualification for a reduced tax rate. For example, REITs, some foreign corporations, and MLPs do not qualify for reduced tax rates. This is because REITs and MLPs have a corporate structure that allows them to avoid paying federal income tax. They are known as "pass-through" corporations because they do not pay federal income tax as long as certain conditions are met, allowing them to reward investors with more significant dividends. 

The IRS handles those payments differently and taxes them more heavily. US investors might consider keeping a REIT and international dividend equities in a retirement account such as an IRA to avoid paying most (if not all) of the taxes that would be delivered in a taxable account.

Unfortunately, that isn't always an option for an MLP due to a concept known as unrelated business taxable income, or UBTI, which can leave investors owing tax on assets in a retirement plan. Many brokers do not enable investors to hold MLPs in an IRA or a Roth IRA to avoid this possible difficulty.

Finally, investors in higher tax rates should be wary of corporations that give special dividends regularly, as they are typically nonqualified payments. As a result, high-income individuals may wish to consider keeping firms known for extraordinary dividends in an IRA rather than a conventional brokerage account. Before investing, learn about the many types of dividends.

The tax rate on a nonqualified payout might be as high as 37%, much above the 20% limit for qualified payments. Investors with higher tax rates should check to see whether a stock's dividend qualifies for the lower tax rate before investing since it might save them money at tax time. 

You should also consider your holding duration and if the firm allows it since these factors can influence whether you should make the acquisition or acquire shares in a tax-advantaged account.

When are nonqualified dividends Tax-free?

Even though nonqualified dividends are taxed at the same rates as regular income, there are some cases where they are tax-free. Suppose you receive a non-dividend distribution from a mutual fund after more than 61 days. In that case, it will be considered a taxable withdrawal. 

Suppose you receive a non-dividend distribution from a corporation after more than 60 days. In that case, the distribution will be considered a taxable earnings distribution. Dividends are paid by companies to the shareholders. These are distributed but not necessarily received. Investors can reinvest dividends to increase their returns. 

If dividends are reinvested, they become a part of the original investment and are no longer a form of distribution. Dividends can be reinvested in the same company or a different one. How to reinvest dividends depends on the type of investment. Stocks can be sold and reinvested in another company or the same company. Mutual funds can be sold and reinvested in the same or a different fund. Bonds can be sold and reinvested in the same or an additional bond.

Bottom Line

Remember, all dividends are taxable, but some are taxed at a lower rate than others. Qualified dividends are taxed at a lower rate than nonqualified dividends, and there are a few situations when they are tax-free. There are also a few situations when nonqualified dividends are tax-free. Stay on top of changes in the tax code and visit the IRS website for more information as it becomes available. Any queries concerning how to claim your qualifying dividends when submitting your taxes should be sent to the Internal Revenue Service (IRS). Stockprices.com gives you ample information on tax, mutual funds, dividends, and much more to make a well-informed decision.