Qualified vs. Non-Qualified Dividends

Qualified and non-qualified dividends differ primarily in how they are taxed. Qualified dividends meet specific Internal Revenue Service criteria and are taxed at lower capital gains rates, while non-qualified dividends are subject to ordinary income tax rates. Eligibility depends on factors such as the issuing company, holding period, and dividend type. Understanding these distinctions helps investors assess their after-tax returns and make informed financial decisions.

A financial advisor can help you find the best dividends for your portfolio and even manage your assets on your behalf.

What Is Dividend Income?

Dividend income refers to payments made by corporations to their shareholders, typically as a distribution of profits. These payments can be issued in cash, additional shares or other assets, depending on the company’s dividend policy. Dividends are commonly paid by established companies with stable earnings, particularly in sectors like utilities, consumer goods and finance.

Investors who own dividend-paying stocks receive these payouts on a scheduled basis, usually quarterly. However, some companies distribute dividends monthly or annually. While dividends provide a source of passive income, not all stocks offer them, as some companies prefer reinvesting profits for growth.

Dividend income can be classified as either qualified or non-qualified for tax purposes. Qualified dividends receive favorable tax treatment, while non-qualified or ordinary dividends are taxed at ordinary income rates. This distinction impacts an investor’s net returns and tax liability.

What Are Qualified Dividends?

If the dividends you receive are classified as qualified dividends, you pay taxes on them at the capital gains rate. The capital gains rate is often lower than the tax rate on non-qualified or ordinary dividends. If you are a lower-income individual, you may owe no federal tax on the portion of your dividends classified as qualified dividends.

Qualified dividend income is taxed at 0%, 15%, or 20%, depending on your income level. It is often more profitable to receive qualified dividends than ordinary dividends. Dividends must meet these criteria to be considered qualified dividends:

The dividend must come from a U.S. corporation or an eligible foreign entity.
If you purchase stock on or before the ex-dividend date and then hold it for at least 61 days before the next dividend is paid, then the dividend is a qualified dividend.
The stock must meet the holding period requirement. To qualify for capital gains tax rates, this period is typically 60 days for mutual funds and common stock, and 90 days for preferred stock.
The dividends are not listed with the IRS as those that don’t qualify for preferential status.
Dividends must not be capital gains distributions or payments from tax-exempt organizations.

What Are Ordinary Dividends?

Most dividends paid by a corporation are ordinary dividends and do not conform to the criteria for qualified dividends. This means they are taxed at your individual marginal income tax rate. The marginal tax rate is the income tax rate paid on the last dollar of income earned by the investor. In almost every circumstance, qualified dividends are better for the investor than ordinary dividends.

If your tax bracket is more than 15 percent but less than the top tax bracket of 37 percent, you pay 15 percent on qualified dividends. If your tax bracket is 37 percent, you pay 20 percent on qualified dividends. This is significant when comparing ordinary dividends and qualifying dividends. A general rule that will save money is to hold investments paying ordinary dividends in tax-advantaged accounts like traditional Individual Retirement Accounts (IRA). Qualified dividends can be held in taxable accounts since the tax rate is likely lower.

The IRS advises taxpayers to assume that any dividend paid on common or preferred stock is an ordinary dividend unless the issuing corporation states otherwise. Businesses that almost always issue ordinary dividends rather than qualified dividends include the following:

Banks and thrifts that pay dividends on deposits
Foreign corporations
Money market funds
Real estate investment trusts (REITs)
Master limited partnerships (MLPs)
Limited liability partnerships (LLPs)
Employee stock ownership plans (ESOPs)

Dividend reinvestment plans (DRIPs) and payments in lieu of dividends are also taxed at ordinary income rates. Dividends will be reported to you on IRS Form 1099-DIV and specified as either ordinary or qualified dividends.

Qualified vs. Non-Qualified Dividends

Qualified and non-qualified dividends differ primarily in tax treatment, eligibility requirements, and holding periods. Understanding these distinctions helps investors anticipate tax liabilities and structure their portfolios more efficiently.

Tax treatment: Qualified dividends are taxed at long-term capital gains rates (0%, 15%, or 20%), while non-qualified dividends are taxed as ordinary income, which may result in higher rates.
Eligibility criteria: Qualified dividends must be paid by a U.S. corporation or an eligible foreign entity, whereas non-qualified dividends include distributions from REITs, master limited partnerships (MLPs) and tax-exempt organizations.
Holding period requirement: To be considered qualified, a dividend requires the stock to be held for at least 61 days within a 121-day timeframe around the ex-dividend date, while non-qualified dividends are not subject to any holding period rules.
Investment implications: Qualified dividends are more tax-efficient for long-term investors, while non-qualified dividends may lead to higher tax liabilities, making them less favorable in taxable accounts.

Bottom Line

Dividend income is a valuable part of your return from stock investing. If you are an income or value investor, you usually choose stocks with higher dividend yields. Capital gains income, which results from stock price increases, is valuable in a rising market, whereas dividend income tends to be more stable during economic downturns. Most dividends are ordinary dividends that are taxed at an investor’s marginal tax rate. Ordinary dividends should be held in a tax-advantaged account if possible.

Tips on Investing

It isn’t always straightforward to determine the types of investments that you should be making. It can be wise to get professional advice from a financial advisor when investing to help you find the right mix of assets. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Not only can a financial advisor help you with your dividend income, but no matter what the market conditions are, an advisor can help you choose investments with an adequate return based on your risk preferences. Find out how much a financial advisor may cost using SmartAsset’s free tool.