If your investments include corporate stocks in the form of either common shares or preferred shares, chances are you'll find yourself receiving dividends at some point. Dividends are distributions of corporate earnings paid to shareholders. And, like any form of income, dividends are subject to income tax.
When it comes to income taxes, there are two types of dividends: qualified dividends and nonqualified dividends, the latter of which are also known as ordinary dividends. Qualified dividends are taxed at significantly lower tax rates than their nonqualified counterparts, so the classification of the dividends you receive has a tremendous impact on your overall income tax liability.
A dividend is a qualified dividend if it meets all of the following requirements:
- The dividend is being paid by a U.S. corporation or a qualified foreign corporation.
- The dividend is recognized by the Internal Revenue Service (IRS) as a qualified dividend. For each dividend payment you receive from a corporation, you receive a copy of Dividends and Distributions (Form 1099-DIV), which will tell you whether the dividend is qualified or not. In addition to capital gain distributions, certain kinds of dividends are not classified as qualified.
- You have held the stocks for which dividends were paid for a certain minimum number of days during a specific period. Generally speaking, you need to have held the stock for more than 60 days during a 121-day period, calculated as beginning 60 days before the ex-dividend date. This date determines if a buyer of stocks is entitled to receive the next dividend payment. For example, buyers who purchase stock before the ex-dividend date receive the next dividend payment; however, when stock is purchased on or after the ex-dividend date, the seller is entitled to receive the next dividend payment.
As mentioned above, you don't need to determine the proper classification of the dividends paid out to you—you'll know the classification when you receive Form 1099-DIV. However, for tax planning purposes, it's a good idea to know as soon as possible how your dividends are classified.
Qualified dividends are taxed at either zero percent, 15 percent, or 20 percent, depending on your income tax bracket. Even at the highest qualified dividend tax rate, you still pay significantly lower tax than you would for a nonqualified dividend.
According to the IRS, nonqualified, or ordinary, dividends are the most common type of corporate distribution. Nonqualified dividends are considered regular income rather than capital gains income and, as such, are subject to the same tax rate as your ordinary income. This means that you pay taxes on nonqualified dividends according to your income tax bracket.
REIT dividend tax
In previous years, it did not make sense for taxpayers to hold real estate investment trusts (REITs) in taxable accounts because REIT dividends were not considered qualified dividends. However, tax changes in the Tax Cuts and Jobs Act of 2017 have implemented a 20-percent pass-through deduction that reduces the rate at which such dividends are taxed. If you're considering holding an REIT in a taxable vehicle, it's best to consult with a tax adviser, as the rules surrounding the pass-through deduction are complicated.
Foreign dividend withholding tax
If your portfolio contains shares in foreign corporations—that is, shares in companies that are incorporated in a foreign country—you may find yourself subject to a dividend withholding tax, which is a tax that a country withholds from investment income paid to nonresident investors.
Every country has a specific withholding tax rate, but this rate may be reduced if the U.S. has negotiated a tax treaty with the country in question. Canada's withholding tax rate, for example, is 25 percent, but because the issue of withholding tax is addressed in the U.S.-Canada tax treaty, Americans investing in Canadian companies are taxed at a lower rate.
Corporate shares can provide significant investment income in the form of dividends, but the tax-savvy investor should be aware of the potential tax consequences of qualified versus nonqualified dividends. In many cases, the holding period of a stock determines whether a dividend is classified as a qualified dividend, thus attracting a lower tax rate. If you're unsure, it's always best to check with a tax account or online service provider, just to be safe.