Published on October 19th, 2021 by Josh Arnold
Revisions added October 21st, 2021 from David Morris
We believe one great way to build wealth over the long-term is to invest in high-quality dividend stocks such as the Dividend Aristocrats, and to reinvest the dividends over time.
You can download an Excel spreadsheet of all 65 Dividend Aristocrats (with metrics that matter such as dividend yields and price-to-earnings ratios) by clicking the link below:
Over time, investors may learn there are different kinds of dividends that they should be aware of, having different tax implications for investors. In this article, we’ll take a look at differences between qualified and ordinary dividends.
First, What is a Dividend?
Let’s start with what a dividend actually is. A dividend is generally a cash payout that is received by shareholders from an entity that is returning excess capital to its owners. Dividends are almost always funded from an entity’s earnings (or earnings equivalent). Therefore, they represent a portion of total return for shareholders.
Dividends can come from a variety of stocks, including foreign and domestic corporations, Real Estate Investment Trusts (REITs), Master Limited Partnerships (MLPs), and any number of stocks as purchased on standard exchanges.
Different Kinds of Dividends
Different dividend-paying securities could be better suited than others, depending upon goals and the tax situation of each individual investor. For this reason, it is important for investors to be thoughtful about which kind of dividends are best, rather than to simply chase the highest dividend yields.
Dividends come in two different forms: ordinary and qualified, and that difference typically results in different treatment for tax purposes. When an investor’s total income and tax situation are considered, the overall effect can be quite meaningful.
Ordinary dividends are taxed as regular or ordinary income, meaning they are taxed in the same way that income from traditional employment is taxed. The investor must pay their standard tax rate on ordinary dividends. Prior to 2003, all dividends were taxed as ordinary dividends, because qualified dividends didn’t exist. Then, qualified dividends were born with tax changes put into place that make dividends more tax-advantaged for investors.
Qualified dividends are taxed at capital gains rates, which are generally lower than standard tax rates. Most dividends paid by US corporations to US-based taxpayers can be classified as qualified, but there are some caveats.
One caveat is that dividend income received from money market funds and REITs is generally classified as ordinary income, irrespective of other criteria. Some dividends are specifically excluded from being qualified by the IRS, including REITs, MLPs, dividends on employee stock options, and those on tax-exempt companies. There are other general conditions that must be satisfied to meet requirements as qualified dividends. Dividends must meet a minimum holding period, and must have been paid by a US company or a qualifying foreign company. In addition, special one-time dividends are always taxed as ordinary income. Dividend must also not be listed with the IRS as non-qualified. Finally, the IRS requires investors to hold shares for a minimum period in order to get the favorable tax treatment of qualified dividends. Common stock and mutual fund investors must hold shares for more than 60 days during the 121-day period that starts 60 days before the ex-dividend date. For preferred stock, the holding period is more than 90 days during a 181-day period that starts 90 days before the ex-dividend date.
Qualifying foreign companies have to meet one of three specified criteria. They must either be incorporated in the US, be eligible for a comprehensive income tax treaty with the US, or be readily tradable on an established exchange in the US. A foreign company that is classified as a passive foreign investment company is automatically excluded from qualified dividends, so all such dividends are categorized as ordinary. Qualified dividends must also come from shares that are not associated with hedging, such as those used for short sales, or call and put options.
The difference between the taxes owed on dividends can be substantial between qualified and ordinary dividends. Qualified dividends, for instance, have a top tax rate of 20%, which is the highest capital gains rate for the highest earners in the US, currently. Most taxpayers would owe 15% or less on qualified dividends, and low earners may even see no federal income tax due at all on their qualified dividends.
Conversely, ordinary dividends are taxed up to 37%, the highest current federal income tax rate. Note that taxpayers do not need to figure out if their dividends are qualified or not for tax purposes, given that brokers must do that for investors. However, if investors are going to receive ordinary dividends, it is best to do so in a tax-advantaged account such as a 401(k) or IRA.
Qualified and Ordinary Dividend Examples
Now that we’ve covered what criteria must be met for qualified dividends, let’s take a look at a real world example of each kind of dividend.
One example of a stock we like that pays US investors qualified dividends is AT&T (T). We like AT&T for a variety of reasons, and its favorable tax treatment eligibility is just one more. The company is a leader in telecommunications, and has paid rising dividends for the past 36 years in a row. We believe AT&T stock is undervalued, and it pays shareholders a massive 8.2% dividend yield. Provided shareholders meet the holding period criteria, these dividends can be received at the investor’s capital gains tax rate, which is generally lower than the tax rate on ordinary income.
An example of a stock we like that is not eligible for qualified dividends is Omega Healthcare Investors (OHI), a REIT focused on skilled nursing facilities in the US. We like Omega for its 8.5% dividend yield and nearly two decades of consecutive dividend increases, as well as its exposure to the trend of an aging US demographic.
Each of these stocks offer advantages to shareholders. These advantages may also vary according to differing brokerage accounts. For so-called taxable accounts, qualified dividends may win out, while for certain retirement or non-taxable accounts, offering tax deferral, ordinary dividends can be a winner. All else being equal, qualified dividends are often the best way to go.
The question of whether an investor should hold securities of companies that pay qualified dividends is an important one, particularly if the investor holds a large amount of stocks, and/or is in a high income tax bracket.
Generally speaking, ordinary dividends are taxed higher, as much as roughly double the rate of qualified dividends, depending upon the specific tax situation, so the difference can be sizable.