Many investors want to know what is the difference between Ordinary Dividends and Qualified Dividends; in this article, we deep dive into dividends and why it is essential to understand the differences.
What Are Dividends?
As someone who chooses to invest in Stocks or Shares, you expect to make a profit. There are essentially two ways in which you expect to be rewarded.
- The appreciation (increase) in the Stock Price
- The payment of a Dividend
The Dividend is a way for a company to reward its shareholders for their investment by redistributing a portion of (after-tax) profits to them.
Ordinary Dividends vs. Qualified Dividends
Ordinary dividends are usually taxed via standard income tax. Qualified Dividends are typically either regular cash dividends or extra dividends that “Qualify” for lower tax treatment in the USA. As an investor, you are subject to normal taxation on your profits by either Income Tax or the lower Long-Term Capital Gains Tax.
The Income Investor
If you want to get an almost guaranteed return on your investments through dividends, then you are investing for a regular income, as dividends can be paid out yearly, quarterly, or even in some cases on a monthly basis.
Investors who specifically seek to make their profits from dividends are often referred to as Income Investors.
What is Ordinary Dividend?
There are three commonly known types of dividend payments.
1. Regular Cash Dividend
Regular Cash dividend, the most common type of dividend payment, usually released annually, quarterly, and sometimes monthly.
2. Extra Dividend or Special Dividend
Extra Dividend is a special dividend, usually a large one-off payment to shareholders. For example, a company may have had a particularly great fiscal year and has already accumulated a significant amount of cash on its books.
If this company does not have any specific investments to make with this extra cash, such as investing in new manufacturing or research facilities or possible competitor acquisition, then it may choose to return some of these profits to shareholders as a sign of goodwill.
3. Liquidating Dividends
Liquidating Dividend is usually paid if there are any left-over or allocated funds during a company’s liquidation. Because this form of dividend is considered a return of capital to shareholders, it is typically tax-free.
What is a Qualified Dividend?
Qualified Dividends are typically either Regular Cash Dividends or Extra Dividends that “Qualify” for different Tax Treatment in the USA. As an investor, you are subject to taxation on your profits by either Income Tax or the lower Long-Term Capital Gains Tax.
As an employee, you are taxed on your Income e.g., Income Tax.
But the government wants to encourage Long-term investing in US companies, not short-term speculation and therefore allows for a lower rate of taxation for longer-term investors by allowing for qualified dividends.
For more information, see What is a Qualified Dividend.
Ordinary vs. Qualified Dividend Comparison
|Comparison||Ordinary Dividend||Qualified Dividend|
|Tax Applied||Income Tax||Long-Term Capital Gains Tax|
|Holding Requirements|| |
Must hold stock 2 days before ex-dividend date
Must hold stock 60 days before ex-dividend date (for Common Stock) or 90 Days before ex-dividend date (for preferred stock)
|Company Requirements||None||Company Incorporated in the US/US Territory – Company Stock Traded on a U.S Stock Exchange – Foreign Corporation in a Country eligible under a specific tax treaty.|
|10% Ordinary Income Tax Rate||10%||0%|
|15% Ordinary Income Tax Rate||15%||0%|
|25-35% Ordinary Income Tax Rate||25% – 30%||15 – 18.8%|
|39.6% Ordinary Income Tax Rate||39.6%||20 – 23.8%|
Table 1: Ordinary vs Qualified Dividend Comparison & Dividend Tax Rates.
As you can see, the regulations can make a significant difference to your dividend income. If you hold the stock for longer periods and are in the 10% to 15% tax bracket, your income from dividends will be effectively tax-free. And for the other tax brackets, there is a reduction in taxation by 40 to 50%, e.g., from 25% to 15%.
This is as long as your dividend award does not take you into the 25% or above tax bracket, in this case, you would be charged for any dividend in that bracket at the appropriate rate.
Tax Implications of Qualified & Ordinary Dividends
If you have managed your income investing process properly, they will qualify as Qualified Dividends; therefore, when you submit your IRS Form 1099-div with your tax return, you will need to ensure you select box 1b to state they are Qualified Dividends to ensure you get lower taxation. Financial advisors can provide further input on completing your form properly.
Video: Ordinary vs. Qualified Dividend Taxation
Ordinary vs. Qualified Dividends Summary
So, if you are investing for income, it is extremely important to understand if the company you are investing in qualifies for Qualified Dividends and that you are within the correct holding times.
Reducing your taxes as a long-term investor and an income investor will make a significant impact on your overall investment return, especially when compounded over the years.